ESSAYS IN INTERNATIONAL FINANCE

ESSAYS IN INTERNATIONAL FINANCE are published bythe International Finance Section of the Department ofEconomics of Princeton University. The Section sponsorsthis series of publications, but the opinions expressed arethose of the authors. The Section welcomes the submissionof manuscripts for publication in this and its other series.Please see the Notice to Contributors at the back of thisEssay.

The author of this Essay, Robert N. McCauley, is a senioreconomist at the Bank for International Settlements. He hasalso served as head of the International Finance Departmentin Research at the Federal Reserve Bank of New York,where he was lead economist to the interagency bank super-visors’ committee charged with rating country risk. In addi-tion to teaching courses on international finance and themultinational firm at the University of Chicago’s GraduateSchool of Business, Mr. McCauley has written widely ontopics such as bond-market volatility, offshore lending to U.S.corporations, direct foreign investment in the United States,and national differences in the cost of capital. He is a co-author, most recently, of “The Euro and European FinancialMarkets” (1997) and of Dodging Bullets: Changing U.S.Corporate Capital Structures in the 1980s and 1990s, forth-coming from MIT Press.

PETER B. KENEN, DirectorInternational Finance Section

INTERNATIONAL FINANCE SECTIONEDITORIAL STAFF

Peter B. Kenen, DirectorMargaret B. Riccardi, EditorLillian Spais, Editorial Aide

Lalitha H. Chandra, Subscriptions and Orders

Library of Congress Cataloging-in-Publication Data

McCauley, Robert N.The euro and the dollar / Robert N. McCauley.p. cm. — (Essays in international finance ; no. 205)Includes bibliographical references.ISBN 0-88165-112-51. Portfolio management—European Union countries. 2. Money—European Union

countries. 3. Euro-dollar market. 4. International finance. 5. Banks and banking,International. I. Title. II. Series.HG4529.5.M4 1997332.4′56094073—dc21 97-40211

CIP

Copyright © 1997 by International Finance Section, Department of Economics, PrincetonUniversity.

All rights reserved. Except for brief quotations embodied in critical articles and reviews,no part of this publication may be reproduced in any form or by any means, includingphotocopy, without written permission from the publisher.

Printed in the United States of America by Princeton University Printing Services atPrinceton, New Jersey

International Standard Serial Number: 0071-142XInternational Standard Book Number: 0-88165-112-5Library of Congress Catalog Card Number: 97-40211

CONTENTS

1 INTRODUCTION 1Framework and Toolkit 4Baselines and Caveats 6

2 THE TRANSITION PERIOD 7Private Asset Managers 7Central Banks 13Volatility 17Summary 19

3 THE EARLY YEARS OF THE ECB 20Private Asset Managers 20Central Banks 21Volatility 22Summary 23

4 TOWARD THE STEADY STATE 24

The Euro as an Anchor Currency 24Private Asset Managers 32Central Banks 39Global Liability Managers 41Volatility 45Summary 49

5 CONCLUSIONS 50

APPENDIX A: QUANTITATIVE EFFECTS OF PORTFOLIO SHIFTS 54Effects of Redistributing Seigniorage 54Effects of Portfolio Shifts 55

APPENDIX B: DOLLAR/MARK POLARIZATION AND THE SWISSFRANC 56

APPENDIX C: RESOURCES, CONSTRAINTS, AND INCENTIVESOF EUROPEAN OFFICIAL RESERVE MANAGERS 58Switches into Dollars in the Transition Stage? 58Excess Dollars in the Long Run? 62

APPENDIX D: EUROPEAN MONETARY UNION AND THESTRUCTURE OF THE FOREIGN-EXCHANGE MARKET 66

APPENDIX E: CURRENCY INVOICING OF INTERNATIONALTRADE 69

REFERENCES 73

FIGURES

1 Changes in Forward Exchange Rates against the Mark 3

2 Sensitivity to Movements in the Mark against the Dollar 5

3 The Nominal Effective Dollar Exchange Rate and EMSRealignments 15

4 Ten-Year Yield Differentials and European Exchange Rates 16

5 The Mark against the Dollar 18

6 The Probability Distribution of the Mark against the Dollar 19

7 The Geography of Exchange-Rate Sensitivities 26

8 Gold-Price Sensitivity to Movements in the Mark againstthe Dollar 29

9 Private Interest Rates in Europe 35

10 Spreads of Ten-Year Government Yields over Interest-Rate Swap Yields 37

11 The International Roles of the Euro, Dollar, and Yen 40

12 Output Gaps 47

13 Effective Dollar Volatility and European Currency Cohesion 50

BOX

1 Case Study: Japanese Life Insurers 10

TABLES

1 Expected Participation in Monetary Union at the Outsetand Sovereign Credit Ratings 2

2 Foreign Holdings of Bank Deposits at End of 1996 8

3 International Holdings of Securities Denominated inCore EU Currencies at End of 1996 9

4 European Monetary Union and Foreign-ExchangeTurnover in April 1995 12

5 Composition of Nonindustrial-Country Reserves at Endof 1996 14

6 Exchange-Rate Regimes and Policies in Central Europe 27

7 Derivatives Transactions in Private Money-MarketInstruments in Euros, Dollars, and Yen 34

8 Transactions in Interest-Rate Swaps and Swaptionsin Euros, Dollars, and Yen 36

9 Derivatives Transactions in Long-Term GovernmentSecurities in Euros, Dollars, and Yen 38

10 International Security Issues by Size and Currencyfrom 1990 to 1995 43

11 Currency Composition of Developing-Country Debtat End of 1996 44

12 Volatility of Nominal Effective Exchange Rates 48

13 International Uses of Major Currencies Before andAfter the Euro 52

B-1 Holdings of Mark, Swiss Franc, and Dollar Bank Depositsby Residents of Core EU Countries at End of 1996 57

C-1 The Composition of EU Foreign-Exchange Reservesat End of 1996 59

C-2 Reserve Pooling of ECU 50 Billion at the EuropeanCentral Bank at End of 1996: Three Scenarios 62

C-3 Surplus Foreign-Exchange Reserves of Euro Area:Various Recent Estimates 64

C-4 Cross-Border Transactions in Bonds and Equities 65

D-1 Foreign-Exchange Turnover in Emerging Currencies 68

D-2 Turnover in Emerging Currencies, by Currencyin April 1996 69

E-1 Invoicing of International Trade by Currency 71

THE EURO AND THE DOLLAR

This work has benefited from discussions at the Bank for International Settlementsbut should be viewed as the work of the author. The author would like to thank, inparticular, Svein Andresen, Steve Arthur, Florence Béranger, Henri Bernard, JosephBisignano, Andrew Crockett, Paul De Grauwe, Gabriele Galati, Giorgio Glinni, SergeJeanneau, Jean-Marie Kertudo, Charles Kindleberger, Frederick Marki, Will Melick,Denis Pêtre, Georges Pineau, Fabrizio Saccomanni, Jeffrey Shafer, Frank Smets, KostasTsatsaronis, and William White.

1 Introduction

Monetary union in Europe holds the promise of profound change forinternational finance. A single currency, the euro, is to circulate wherepowerful markets once alternated between reinforcing and opposing—and sometimes overwhelming—repeated national efforts to achievemonetary convergence. The economies sharing the euro may face theworld as the largest single-currency area and the largest single tradingbloc.

As this long-standing deadline has approached, it has gained credibil-ity. Less than two years ago, the consensus drew a narrow circle aroundGermany’s neighbors; now, the circle has widened. The quotidian pollin the bond market also shows that investors expect the euro to come—that is, bond buyers have increasingly signaled their belief that someEuropean currencies will enjoy stability against the deutsche mark(Table 1 and Figure 1).1

This essay makes the assumption that the euro is coming and seeksto understand the implications of its arrival for the U.S. dollar. Inparticular, it investigates the motives for, and implications of, shifts offunds by international portfolio managers in response to the euro’sintroduction. It suggests that private portfolio shifts are likely to proveof greater importance than the much-discussed changes in the compo-sition of central banks’ foreign-exchange reserves and maintains thatliability managers will play a generally overlooked role in determiningthe long-run relation between the dollar and the euro.

1 Figure 1 represents an implementation of the Svensson (1991) test for the credibilityof exchange-rate bands. It uses private interest rates because, unlike government rates, theyhave similar default and country-risk characteristics; see De Grauwe (1996a) and BIS (1996b,1997b). Lascelles (1996, p. 8) reminds us that market expectations can prove wrong.

1

The burden of the essay is that the effects on the dollar of portfolio

TABLE 1

EXPECTED PARTICIPATION IN MONETARY UNION AT THE OUTSET

AND SOVEREIGN CREDIT RATINGS

(in percentages)

Poll Taken in Foreign-Currency Rating

CountryJanuary1996

August1996

January1997

August1997 Moody’s S&P IBCA

Germany 100 100 100 100 Aaa AAA AAA

France 97 100 100 100 Aaa AAA AAA

Netherlands 76 100 100 100 Aaa AAA AAA

Belgium 79 95 100 100 Aa1 AA+ AA+

Austria 79 93 97 96 Aaa AAA AAA

Ireland 60 82 88 96 Aa1 AA AA+

Finland 36 48 76 91 Aa1 AA AAA

Spain 7 7 31 90 Aa2 AA AA

Portugal 0 4 32 84 Aa3 AA− AA−

Italy 2 3 19 67 Aa3 AA AA−

Denmark 50 43 25 16 Aa1 AA+ AA+

Sweden 7 13 13 4 Aa3 AA+ AA−

United Kingdom 22 8 4 1 Aaa AAA AAA

Greece 0 0 0 1 Baa1 BBB− BBB−

SOURCES: Consensus Economics, Consensus Forecasts, August 1996 and 1997, p. 26;Moody’s, Standard & Poor, and IBCA.

NOTE: The polls of over 200 financial and economic forecasters indicate the percentageof respondents predicting that countries will join monetary union at the outset. Respondents’assumptions regarding the likely starting date differ. Luxembourg, rated Aaa and AAA,respectively, was not included in the poll.

shifts in response to the arrival of the euro are easy to overstate andare often overstated. Common arguments that ascribe the dollar’sstrength against the mark through the summer of 1997 to the pro-spective introduction of the euro are one-sided. Although it may bethat the prospect of the euro has led to portfolio shifts that havestrengthened the dollar, it is certainly true that a cyclically strongdollar has paved the way for the euro. In the early years of the euro,any previous shifts into the dollar in anticipation of the euro mayreverse themselves as the European Central Bank (ECB) consolidatesits credibility and central banks find that they can invest in a deeptreasury-bill market in euros.

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on the exchange rate than its predecessors must be balanced againstthe prospect of the more stable transatlantic interest-rate differentialsthat will result from the broader domain of policymaking in Europe. Inany case, monetary union can be expected to raise the volatility to theeffective dollar, owing to the uniformity of exchange-rate changeagainst a large European trading bloc; any increase in dollar/eurovolatility over dollar/mark volatility will only accentuate this tendency.

Framework and Toolkit

To advance the analysis of the dollar/euro exchange rate, I set out aframework for addressing the problem, unpack a useful toolkit, andconsider some of the forces bearing on the dollar. The direction ofthese forces affords some insight into tendencies of both the level andthe volatility of the dollar/euro rate.

The responses of three classes of portfolio managers are considered—official reserve-asset managers, private asset managers, and public andprivate liability managers—during (at least) three stages of monetaryunion—the period before the irrevocable fixing of conversion ratesbetween existing European currencies and the euro, the period beforethe ECB has consolidated its credibility, and the steady state beyondunion. Monetary union is itself a threefold joint event: it eliminatesexchange risk, creates much broader financial markets, and introducesa new central bank with credible antecedents but no independentreputation. Such a mixture, with three actors, three stages, and threetransformations, leaves plenty of room for reasonable disagreement.

To help assess what the euro might mean for the dollar, I open a two-drawer toolkit. First, I treat the determination of the exchange rate asa price that balances the demand for, and supply of, financial assetsdenominated in different currencies (Branson and Henderson, 1985).These assets are taken to be imperfect substitutes, so that their suppliesand demands affect the exchange rate. Still, the quantitative impact ofsubstantial portfolio shifts can be fairly subtle (see Appendix A).

Second, I employ an empirical regularity. The observation, firstmade in the late 1970s (Brown, 1979), is that when the deutsche markweakens against the dollar, most other European currencies also fallagainst the dollar but strengthen a little against the mark. Conversely,when the dollar falls against the mark, it also falls against most otherEuropean currencies, but to a lesser extent, so that they fall somewhatagainst the mark.2 Figure 2 shows the estimated coefficients from a

2 Subsequent observations and accounts include Frankel (1986), Giavazzi andGiovannini (1989), Group of Ten (1993), Galati (1997), and Galati and McCauley (1997).

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near one means that a currency moves with the mark, whereas anobservation near zero means that it moves with the dollar. Typically,the currencies of Germany’s neighbors—and, more recently, thePortuguese escudo and the Spanish peseta—track the mark quiteclosely, and the British pound, Italian lira, and Swedish krona sharehalf or more of the mark’s movements.

Baselines and Caveats

Three caveats are in order at the outset. First, even as profound adevelopment as monetary union will make itself felt against a back-ground of cyclical and secular forces bearing on exchange rates. Anybaseline outlook for the dollar’s exchange rate against European cur-rencies must reflect the relationship between the business cycle inEurope and in North America and associated interest-rate movements.Thus, the recovery of the dollar in the two years after its trough in thespring of 1995 must be ascribed, first and foremost, to the contrastbetween the U.S. “hare” and the European “tortoise.” By the sametoken, an upswing in the European economy in 1999 accompanied bya sluggish U.S. economy would make for European currency strengthirrespective of monetary union. Similarly, the long-standing U.S. current-account deficit and the consequent cumulative erosion of the U.S.international asset position will continue to weigh on the dollar’s valueregardless of monetary union. The effects of monetary union discussedin this essay should therefore be understood as deviations from a baselineset by such cyclical and secular factors. In addition, markets may springsurprises that might reinforce or counteract the effects set out here.

Second, this essay musters and relies upon evidence on the currencycomposition of asset stocks, including official reserves, private assets,and international debts. These stocks will not remain unchanged in theyears leading up to monetary union. In particular, the amount andcomposition of official reserves may change markedly if exchange ratesmove sharply. Inferences from such cash positions are risky, moreover,because off-balance-sheet positions can transform exposures (Garber,1996, pp. 9–11).

Finally, the necessary division of the future into distinct periods mayprove artificial. If market participants become convinced of a long-termoutcome, prices in an intermediate stage will incorporate this convic-tion, as demonstrated by the narrowing of interest differentials inEuropean bond markets. The force of this last caveat will remainlimited, however, as long as market commentary on the euro continuesto be diverse and even contradictory.

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In the discussion that follows, the first organizing principle is time. Aseparate section for each of the three periods assesses the effect of thebehavior of private asset managers and central banks (and global liabilitymanagers in the steady state) on the level of the dollar and then takesup the question of exchange-rate volatility in each phase.

2 The Transition Period

The basic question in the months remaining before the introduction ofthe euro is how portfolio managers will react to the change in currencymanagement in Europe. The ECB will be able to claim a stronglineage, but uncertainties necessarily accompany its approach. Willinvestors sell European assets and buy dollars?

Private Asset Managers

Market participants accept monetary union as increasingly likely butstill ask questions. Which countries will participate? How will paritiesbe determined? What will be the background and character of theECB’s policymaking body? What will be the ECB’s objectives andinstruments? What will be its foreign-exchange policy? What will bethe form of any exchange-rate arrangement (ERM II) with currenciesnot participating at the outset? Portfolio shifts in response to theseuncertainties can affect the level of the dollar.

For private investors inside the prospective currency area, the effectsof such uncertainties could offset one another in the area as a whole.Although residents of countries with the best inflation records may seekto move assets out of their home currencies, those of countries with lessgood records may feel reassured and may move assets into their homecurrencies. To get a net outflow from the euro area would require asituation in which the uncertainties attached to the prospective newcurrency range well beyond questions about the future behavior of theECB relative to the recent behavior of its constituent central banks.3

Private investors outside the euro area, however, might be led bythese uncertainties to take defensive positions by shifting their assetsinto dollars or Swiss francs (at given interest-rate differentials). Thispossibility gains plausibility from the defensive character of currentforeign investment in European fixed-income assets. Holders of bank

3 Something along these lines drew the attention of an official Swiss commissioncharged with assessing the implication of the euro for the Swiss franc. It considered thepossibility that portfolio outflows from the euro area might reach such a volume as to callfor a policy of (temporarily) pegging the Swiss franc to the euro (Commission, 1996).

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deposits denominated in European currencies show a strong bias towardthe “core” European currencies, and the mark in particular, regardlessof the residence of the holders of the deposits (Table 2).4 There appears

TABLE 2

FOREIGN HOLDINGS OF BANK DEPOSITS AT END OF 1996(in billions of U.S. dollars and percentages)

Residence of Holder

CurrencyCore EUCountry %

Other EUCountry %

Rest ofWorld % Total %

German mark 98.0 (64) 53.1 (57) 77.7 (51) 228.8 (57)French franc 18.2 (12) 15.0 (16) 30.0 (20) 63.2 (16)Dutch guilder 16.6 (11) 7.7 (8) 16.9 (11) 41.2 (10)Belgian/Lux’bg franc 12.3 (8) 8.9 (10) 16.4 (11) 37.6 (9)Austrian schilling 1.2 (1) 0.6 (1) 1.5 (1) 3.2 (1)ECU 7.4 (5) 7.5 (8) 9.9 (6) 24.8 (6)

Subtotal: Core EUcurrencies

153.7 (100) 92.8 (100) 152.4 (100) 398.8 (100)

Italian lira 15.4 (10) 16.1 (17) 14.1 (9) 45.6 (11)British pound 17.2 (11) 5.9 (6) 83.8 (55) 106.9 (27)Other currencies 7.8 (5) 13.0 (14) 9.2 (6) 30.0 (8)

Subtotal: Other EUcurrencies

40.4 (26) 35.0 (38) 107.1 (70) 182.5 (46)

Total: EU currencies 194.1 (126) 127.8 (138) 259.5 (170) 581.3 (146)

U.S. dollar 109.2 (71) 200.1 (216) 340.6 (224) 649.9 (163)Swiss franc 16.8 (11) 13.3 (14) 32.8 (22) 62.9 (16)Japanese yen 12.1 (8) 19.5 (21) 26.4 (17) 58.0 (15)

Grand total 332.1 (216) 360.7 (389) 659.3 (433) 1,352.1 (339)

SOURCE: BIS.NOTES: Nonbank holdings only; holdings abroad of a given currency by residents of the

country of issue are excluded (for example, deutsche mark holdings abroad by Germanresidents are excluded). For Austria, Denmark, Ireland, Finland, Spain, and Sweden, onlythe cross-border position in domestic currency is available.

to be almost as marked a preference in international holdings ofsecurities (Table 3). Recall that French franc deposits have consistentlyyielded more than mark deposits for over a decade in which the franchas reverted to its central rate after every depreciation. These aggregateportfolios appear to be managed with an eye to preserving capital ratherthan achieving high returns. The portfolio bias toward the mark thus

4 For the recent growth of cross-border deposits in Europe, see Monticelli and Papi(1996, chap. 3).

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suggests an aversion to risk that could lead to net shifts out of core

TABLE 3

INTERNATIONAL HOLDINGS OF SECURITIES DENOMINATED IN CORE EU CURRENCIES

AT END OF 1996(in billions of U.S. dollars)

Currency

In CoreEU

Banksa

In OtherEU

Banksb

In Banksin Rest

of World

TotalBank

Holdings

NonresidentHoldings of

Gov’t Bonds

InternationalSecurities

Outstandingc

German mark 144.7 59.2 29.1 233.0 308.5d 349.8French franc 25.4 6.2 7.1 38.7 79.9 168.7Dutch guilder 8.3 3.6 3.1 15.0 — 95.9Belgian/Lux’bg franc 8.4 1.4 0.2 10.0 — 56.3Austrian schilling 0.0 0.0 0.0 0.0 — 3.7ECU 18.3 13.9 1.1 33.3 — 74.7Total 205.1 84.3 40.6 330.0 — 749.1

SOURCES: National data and BIS.a Banks in Austria, Belgium, France, Germany, Luxembourg, and the Netherlands.b Banks in Denmark, Finland, Ireland, Italy, Spain, Sweden, and the United Kingdom.c Includes international bonds and medium-term euro notes.d End of June 1996.

European currencies in the face of the above-mentioned uncertainties.5

One case in point is that of Japanese life insurers (see Box).Another way of looking at the distribution of international deposits in

European currencies, however, is to interpret it as merely reflectingthe role of the deutsche mark as an international currency. That is,rather than reflecting risk aversion, international holdings of marks,particularly bank deposits, may result from nothing more than the closesubstitutability of the mark with other European currencies and theease with which it can be transformed into any one of them. On thelatter point, not only is dollar/mark trading far larger than the tradingof any other European currency against the dollar, the mark is also theinterbank vehicle for almost all trading between Continental currencies.When a bank exchanges a customer’s French francs for Italian lire, for

5 The Deutsche Bundesbank (1997) recently drew attention to the foreign holdings ofdeutsche marks in order to warn that the transition to the euro must be handled with careto ensure that the high degree of confidence in the mark is sustained and passed on to theeuro. The Bundesbank measured foreign holdings at DM 1.4 trillion (about $800 billion)at end-1996, excluding trade credits and direct investments in Germany. The Bundesbank(1997, p. 30) characterized the “outstanding international role of the Deutsche Mark [as]. . . undoubtedly a considerable challenge to the planned single European currency—theeuro.”

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CASE STUDY: JAPANESE LIFE INSURERS

Another indication of a strong, albeit recent, bias in private portfolios toward deutschemark assets is the distribution of the foreign assets of Japanese life insurance companies.I examine the distribution of bond holdings because Japanese insurers’ bank deposits inEurope have been minimal (with the exception of Swiss franc deposits from 1995 to1997). This evidence is worth consulting because there are few reliable breakdowns ofthe bond holdings of any important class of internationally active institutional investor.These mostly mutual life insurance companies represent the largest single group ofinstitutional investors in the world’s largest creditor country, but no claim is made fortheir representativeness. The earliest detail on their portfolios shows them to havefavored higher-interest-rate investments in Europe, that is, the portfolios were stronglytilted away from the deutsche mark in September 1991: they had only 3 percent of theirbond portfolio in German bonds and 24 percent in other European bonds (see tablebelow). Against a background of overall shrinkage in the foreign-bond holdings of theseinstitutions, and the increasing weight placed within their foreign-bond holdings on euro-yen bonds (see McCauley and Yeaple, 1994, pp. 19–33), these portfolios seem never tohave recovered from the shock of the ERM crises of 1992–93. By September 1995,7 percent of their foreign-bond portfolio was invested in German bonds, only 3 percentin French bonds, and only 1 percent in ECU bonds.

FOREIGN-BOND HOLDINGS OF JAPANESE LIFE INSURERS

(in percentages)

Currency 1991 1992 1993 1994 1995 1997

Europe 27 23 30 19 12 11German mark 3 6 11 6 7 5French franc 9 7 12 9 3 1ECU 6 4 2 2 1 1British pound 5 3 4 1 1 3Spanish peseta 1 1 0 0 0 0Other 3 2 1 0 0 1

Dollar bloc 63 69 61 52 43 58U.S. 32 35 38 39 37 54Canadian 21 24 17 8 5 3Australian 10 10 7 5 1 1

Othera 11 9 8 30 45 31

Total (¥ trillion) 11.5 10.6 7.9 5.1 6.5 13.2Memorandum: Ratio of Germanbonds to total German, French,and ECU bonds 0.15 0.30 0.44 0.30 0.63 0.76

SOURCE: Koo, “Japan and International Capital Flows,” 1992–1996, andpersonal communication for 1997 data.

NOTE: Data are for September, except for 1997, when they are forMarch. Figures are rounded and may not sum to 100.

a Mostly euro-yen bonds.

example, it will typically transact a pair of exchanges in the interbankmarket: marks against lire and francs against marks. Of an estimated$150 billion in transactions among European Union (EU) currencies inApril 1995 (shown with double-counting in Table 4 as $300 billion), thedeutsche mark was on one side of the transaction in over $140 billion.6

Under these conditions, a European corporate treasury trying tominimize its transactions costs while reducing its working capital wouldcentralize its bank deposits in European currencies in deutsche markaccounts. On this reading of the evidence, the distribution of assetstocks across currencies in Table 2 reflects the manner in which marketparticipants have already exploited the mark’s vehicle property toeconomize on their holdings of bank deposits in different Europeancurrencies. An important implication is that after monetary union,these international bank deposits might not decline as one mightimagine.7 That is, to the extent that deutsche mark deposits are al-ready held to make payments at one remove in either Dutch guildersor French francs, then the arrival of the euro may not much shrink thedemand for the participating currencies. I return to this point in thenext section.

What does the evidence show? To some analysts, the prospectivemovement of private investors out of the deutsche mark is already areality. A Swiss commission (Commission, 1996, p. 2) examining Swisspolicy options in the face of monetary union claimed:

The fear that the future single currency does not have the quality of theDM or other currencies belonging to the DM-group, induces investors toexchange these currencies, in particular the DM, into other strong interna-tional currencies, among others into the Swiss franc. As a result, there arestrong tendencies for the Swiss franc to increase in value.

A variant is the observation that deutsche mark bonds, especially thosematuring in the next century, yield a high interest rate because ofuncertainty regarding the euro. The claimed effect of such shifts hasbeen summarized with the provocative statement that “the euro . . . isalready . . . a weak currency” (Persaud, 1996, p. 3). Events that makethe euro more or less likely are thus seen to weaken or strengthen themark against the dollar.

6 Here and throughout, “billion” equals one thousand million.7 Baumol’s (1952) argument that the transactions demand for money rises with the

square root of spending, applied to a variety of currencies that become one currency,implies that transactions bank balances will decline. See Honohan (1984) for theopposite case, when sterling bifurcated into the British pound and the Irish punt.

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TABLE 4EUROPEAN MONETARY UNION AND FOREIGN-EXCHANGE TURNOVER IN APRIL 1995

(in billions of U.S. dollars and percentages)

Actual Turnover againstHypothetical,

with MonetaryUnion (total

less all EMS)cCurrency Dollara Marka All EMSb Totala % %

U.S. dollar — 365 714 1,313 84% 1,313 92%EU currencies/eurod 714 140 300 1,099 70% 799 56%

German mark 365 — 140 584 (443)French franc 72 50 53 127 (74)Dutch guilder 18 7 9 27 (18)Belgian/Lux’bg franc 20 8 9 29 (20)Austrian schilling 5 3 3 8 (5)ECU 25 10 11 36 (25)Irish punt 2 0 1 3 (2)Finnish markka 3 2 2 5 (3)Spanish peseta 25 8 8 33 (25)Portuguese escudo 2 1 2 4 (2)Italian lira 39 9 10 49 (39)Danish krone 17 5 6 23 (17)Swedish krona 15 9 10 26 (15)British pound 103 29 32 140 (108)Greek drachma 2 1 2 4 (2)

Japanese yen 329 33 371 24% 371 26%Swiss franc 86 26 116 116Canadian dollar 49 1 50 50Australian dollar 39 40 40Emerging currencies 23 25 25

Hong Kong dollar 14 15 15Singapore dollar 5 6 6South African rand 4 4 4

Other reporting coun-tries and unallocated 71 18 130 130

Grand total (-: 2) 1,313 584 1,099 1,572 100% 1,422 100%

SOURCES: BIS, Central Bank Survey 1995, Consensus Economics, Consensus Forecasts,August 1997, and author’s calculations.

NOTE: Because the table reports the turnover (net of local interdealer double-counting) forwhich a given currency appears on one side of a transaction, each transaction is counted twice.The grand total is therefore divided by two and set to 100 percent. Estimates are shown initalics; the contribution of EU currencies to euro turnover is shown in parentheses. Compo-nents are rounded and may not sum to totals.

a Decompositions for EU currencies other than the mark, franc, ECU, and pound are esti-mated using each currency’s local-currency trading as a proportion of such trading for all otherEMS currencies.

b Estimated EMS totals for currencies other than the French franc or British pound arecalculated as the currency total less that currency’s trading against the dollar (local tradingagainst other currencies is negligible). The French franc (or British pound) EMS total isestimated as the total less the sum of its trading against the dollar, against the yen in Tokyo,against the Swiss franc in Zurich, and against the yen, Swiss franc, Canadian dollar, andAustralian dollar in Paris (or London).

c Because some intra-EMS transactions using the U.S. dollar as a vehicle will disappearunder monetary union, the currency shares shown overstate the importance of the euro, under-state the importance of the yen, and correctly represent the importance of the dollar.

d EU currencies (excluding the ECU) are ordered according to poll respondents’ views onthe probability of countries joining monetary union at the outset (Consensus Economics,Consensus Forecasts, 1997).

All of these claims can be and have been disputed. Thus, the Bundes-bank (1997, p. 30) notes that “the available data on the currencystructure of international assets (even when interpreted with caution)argue against the supposition of ‘a flight out of the Deutsche Mark.’”Indeed, Table 2 was originally assembled with end-1995 data, whichwere not very different from the end-1996 data. Quite apart from anyflight from the mark, non-German European investors may shift theirmarks into Swiss francs to balance the risk of their dollar holdings(Appendix B). As for the effect of the prospect of monetary union onGerman bond yields, an International Monetary Fund (IMF) studylooked in vain at scores of monetary union events for evidence ofsystematic effects on German and other European bond yields (Zettel-meyer, 1997).8 Moreover, a variety of analysts marshaled the evidenceto suggest that the slope of the German yield curve was no steeper thanone would expect, given the unprecedentedly low short-term rates andthe historical relation between those rates and the slope of the yieldcurve (King, 1996, p. 12). As for the connection between measures ofthe likelihood of monetary union (Persaud, 1996) and the dollar/markexchange rate, recall the long-standing association of a strong dollar andstrong European currencies against the mark. Although concedinggrounds for both readings, the relation is perhaps better read from leftto right than from right to left. Brighter prospects for broad monetaryunion may have tended to strengthen the dollar, but a cyclically strongdollar has surely paved the way to monetary union.

Central Banks

The question of how the prospect and introduction of the euro mightaffect central banks’ management of their official reserves has attracteda great deal of market comment (see, in chronological order, O’Neill,Bevan, and Brookes, 1996; Keating, 1996; Ruskin, 1996; Owens, 1996;Persaud and Dambassinas, 1996; Brookes, 1996; Parsons, 1996; Golden,1996; Adler and Chang, 1996; Lipsky et al., 1996; Bulchandani, 1997;

8 But one’s confidence in the null finding is undermined by the coding of the eventsaround September 20, 1995, as “ambiguous,” when the clearly dominant event was officialGerman questioning of the policy fitness of certain aspiring countries for monetary union;see BIS (1996b, pp. 101, 103). Zettelmeyer measures that day’s effect on bond yields asa decline in German rates of 6 basis points and a rise in Italian rates of 10 basis points.More recently, the compromise at the Amsterdam intergovernmental conference,accommodating the new French government’s requirements to some extent, saw theGerman bond yields rise, Italian bond yields fall, and the mark slip against the dollar.

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Deutsch, 1997; Alzola, 1997; and Hoffman and Schröder, 1997). It needsto be stressed at the outset that official reserves at the end of 1996, evenafter a year when they grew by a record amount—$200 billion at constantexchange rates to a stock of $1.5 trillion (BIS, 1997b, p. 83)—representonly a fraction of the private portfolios that may react to the introductionof the euro.9

Some central banks outside the Group of Ten (G–10) could also

TABLE 5

COMPOSITION OF NONINDUSTRIAL-COUNTRY RESERVES AT END OF 1996(in billions of U.S. dollars and percentages)

Currency

AllDevelopingCountries %

ofwhich:Taiwan %

EasternEurope % Total %

GlobalTotal %

U.S. dollar 531.9 (71.5) 50.6 (57.5) 34.1 (51.0) 566.0 (69.8) 1,041.5 (68.6)Japanese yen 60.8 (8.2) 13.0 (14.8) 0.0 (0.0) 60.8 (7.5) 105.3 (6.9)Core EU 101.0 (13.6) 20.3 (23.1) 31.2 (46.7) 132.2 (16.3) 303.6 (20.0)

German mark 87.1 (11.7) 20.3 (23.1) 30.5 (45.6) 117.6 (14.5) 246.1 (16.2)French franc 10.1 (1.4) 0.0 (0.0) 0.7 (1.1) 10.8 (1.3) 23.2 (1.5)Dutch guilder 3.8 (0.5) 0.0 (0.0) 0.0 (0.0) 3.8 (0.5) 5.1 (0.3)

British pound 36.4 (4.9) 0.0 (0.0) 0.9 (1.3) 37.3 (4.6) 52.1 (3.4)Swiss franc 13.9 (1.9) 4.0 (4.6) 0.7 (1.1) 14.6 (1.8) 15.4 (1.0)Total 744.0 (100.0) 88.0 (100.0) 67.0 (100.0) 810.9 (100.0) 1,517.8 (100.0)

SOURCES: Hong Kong Monetary Authority, Annual Report 1996; Taiwan authorities; U.S. Treasury,Treasury Bulletin, March 1997, table IFS-2; IMF, and BIS estimates.

NOTES: Developing countries include Hong Kong and Taiwan. Taiwan’s disclosed dollar share asof April 1996 is applied to holdings at the end of 1996; disclosed shares of yen, marks, and Swissfrancs as of August 1995 are reduced proportionately to accommodate the (higher) dollar share ofApril 1996. Core EU currencies include holdings of private ECUs. Dollar reserves of developingcountries are reduced by the current value of the Brady bond collateral held at the Federal ReserveBank of New York and by advance payments for U.S. military exports as reported in the TreasuryBulletin. The reserve composition of Eastern European countries is estimated. The global totalincludes industrial countries.

adopt a defensive strategy in the run-up to monetary union. With $118billion in deutsche mark reserves out of core European reserves of$132 billion at end-1996, the central banks in nonindustrial countriesshow a similar bias toward the deutsche mark (Table 5).10 If thisconcentration of holdings reflects risk aversion, then central-bank

9 For the contrast in the growth of official reserves and private international assets overa generation, see Icard (1996, p. 180).

10 Contrary to Garber’s (1996, p. 6) claim that “all studies of the currency compositionof foreign exchange [reserves] depend on the data contained in the IMF’s AnnualReports,” these data include the reported or estimated reserve compositions of Taiwan,Hong Kong, and Eastern Europe.

14

A further consideration is that a weak dollar has often accompaniedstrains in European exchange rates that have resulted in realignments(Figure 3). But if, as considered above, the dollar benefits from defen-sive portfolio shifts in the run-up to monetary union, the odds rise fora prolonged virtuous circle of strong European cross rates against thedeutsche mark and convergent European interest rates (Figure 4).Aware of the possibility of this virtuous circle, and perhaps also antici-pating a need to offset the cumulative effect of Maastricht-timed fiscaltightening in Europe, market participants seem to expect little resistanceamong European policymakers to a stronger dollar in this period. Evenwhen the Bundesbank raised short-term interest rates in the fall of 1997,citing the dangers of import-price inflation, market participants inter-preted the move less as an attempt to reverse the prior decline than asinsurance against further large movements in the same direction.

Volatility

With respect to the volatility of the dollar/mark exchange rate during thetransition period, should strains arise in the process of monetary union,these could not only weaken the dollar but also increase its volatility.The events of mid-September 1995, when doubts about which Europeancountries would qualify for monetary union came to center stage, serveas an example. Although increased attention to policy performancetended to weaken European currencies against the mark, the dollar alsoplunged 6 pfennigs (4 percent) on September 21 and 22 (Figure 5).Moreover, option prices suggested that expectations of the dollar’s valueone month ahead became more diffuse, and the odds of a sharpchange—for example, of 5 percent or more—shifted from dollarstrengthening to dollar weakening (See Figure 6 and McCauley andMelick, 1996a, 1996b). European events can move the dollar.13

made a more competitive franc vis-à-vis the dollar one of its conditions for supportingmonetary union (along with an “economic government for Europe,” a “solidarity andgrowth pact,” and inclusion of Spain and Italy in the first wave of participants in monetaryunion), the finance minister told a press conference that the “dollar has moved in such away that the problem is not topical, at least for the moment” (quoted in “French govt has‘no problem’ with dlr level — minister,” Reuters, June 16, 1997 [16:39]).

13 The generality of such European influences on the dollar has been questioned.Johnson, (1994, p. 8) found no systematic relation between fairly long periods of high andlow volatility in the French franc/deutsche mark exchange rate, on the one hand, and thevolatility of the ECU/dollar exchange rate, on the other. Still, the “September 1992episode of extreme instability in the Exchange Rate Mechanism (ERM) suggests thatduring shorter intervals, spillover to the dollar from ERM volatility may be present.”

17

3 The Early Years of the ECB

The formation of the ECB and the introduction of the euro shouldrelieve some of the uncertainties cited above. As time goes by, financial-market participants as well as wage and price setters will discern theECB’s character. In this second phase, extending from the inception ofthe euro at least until the disappearance of the constituent nationalcurrencies (scheduled for 2002), the ECB will also give evidence of itsexchange-rate policy. Much of the discussion of this period centers onwhether the ECB will pursue a tough interest-rate policy or will reactwith unusual vigor to a weakening of the euro against the dollar. At thesame time, other uncertainties may arise: interest rates and exchangerates might show volatility as the ECB and market participants gropefor a common understanding of policy targets and instruments andtheir nuances.

Private Asset Managers

Private asset managers might shift funds into the euro upon demonstra-tion of, or indeed in anticipation of, a firm-interest-rate and strong-currency policy on the part of the ECB. The European Commission(1997b, p. 9) casts doubt on “an often heard argument . . . that theECB would attempt to establish early counter inflation credibility byadopting a tight monetary policy stance” on the grounds that “there is. . . no reason to assume that the Bank will not enjoy counter inflationcredibility from the outset.” The Bundesbank’s chief economist dis-missed as a “nice idea” the notion that the ECB would, despite highEuropean unemployment, pursue a particularly restrictive policy at theoutset.15 It will probably be very difficult even after the fact to knowwhether the ECB has shown a bias toward firm rates.16 With respectto exchange-rate policy, one can debate how much European monetarypolicy will respond to exchange-rate movements in the steady state, butseveral considerations suggest that the ECB might put considerableweight on the exchange rate in its early years. Were the euro to weakenduring this period, not only financial-market participants but alsodomestic wage and price setters would look to the ECB’s reaction forevidence bearing on its credibility. Put another way, the first “referen-

15 Otmar Issing, speaking before the European Summer Institute (quoted in Stüde-mann, 1997).

16 One approach would be to look for deviations from a Taylor rule for ECB policy;see Clarida, Gali, and Gertler (1997).

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dum” on the ECB could be conducted in the foreign-exchange market,and the authorities might thus respond vigorously, whatever the cyclicalcircumstances.17

A particular dilemma could arise for the new directors of the ECB ifthe consolidation of credibility were to take on importance against thebackground of a strong U.S. economy and a weak European economy.If some European countries were not to join monetary union from theoutset but were to enter an ERM II, however, dollar weakness couldalso pose challenges. The tendency for most European currencies todecline against the deutsche mark when the dollar does so couldcontinue, with ERM II currencies weakening against the euro when thedollar weakens. Any association of strains in the ERM II with dollarweakness against the euro could put dollar weakness on the agenda atthe ECB. But the salience of dollar weakness would depend on thedesign of ERM II, especially on its fluctuation margins and relatedintervention obligations (Saccomanni, 1996).

Central Banks

The introduction of the euro will make it easier for central banks toinvest in the world’s second-largest reserve currency. Until recently,the Bundesbank’s opposition to short-term finance has kept the Ger-man finance ministry from floating part of its debt as treasury bills. Asa result, many risk-averse central banks were denied their naturalinvesting habitat of short-term government bills and, with some dis-comfort, had to deposit their deutsche mark reserves with banks. Somecentral banks used bond futures to shorten the duration on holdings ofGerman government bonds or used currency forwards to convert U.S.Treasury bills into synthetic deutsche mark treasury bills. But far fromall central banks are able and willing to employ such strategies.

Whatever the debt-management policy of the German government,the other triple-A governments in the euro area will ensure a supply ofeuro-denominated treasury bills that is ample enough to satisfy allcentral-bank demands. Central banks probably should not be expectedto reallocate their portfolios abruptly in January 1999, in response tothis new menu item in the world’s second-largest reserve currency, butit could make it easier for central banks, particularly in emergingmarkets, to diversify thereafter into the euro.

17 Masson and Turtelboom (1997) and Funke and Kennedy (1997) speak of theprivileged policy position that the exchange rate might occupy in the euro’s early days.

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Volatility

In the early days of the ECB, market participants will have to discovernot only the bank’s objectives, but also the way in which it intends touse its policy instruments to achieve those objectives. Participants willneed time to learn to read the nuances of the ECB’s operations. Thechallenge of clearly and simultaneously signaling ECB intentions tomarket participants, given the aim of operating in a number of nationalmarkets with different structures, could make for more volatile moneymarkets and exchange markets.

A reasonable hunch is that the money-market operations by the ECBneed not impart much volatility to money or foreign-exchange marketsif European policymakers value stability. Whatever the importanceplaced on one or more monetary aggregates as an intermediate target,the Bundesbank has, since the bond-market turbulence of 1994, reliedheavily on the fixed-rate tender for its operations. Rather than puttingout a fixed quantity of reserves and letting the price reflect demandpressures, the fixed-rate tender allows quantities to adjust. If, in thefuture, repurchase transactions are to be conducted simultaneously bya number of national central banks, the argument for fixing the ratecould prove very convincing.

One might hope that any monetary implications of the consolidationof internationally held bank deposits denominated in a number ofEuropean currencies will be anticipated, even if not measured exactly,ahead of time and will be handled without destabilizing Europeanmoney markets and the foreign-exchange market. Again, balances indeutsche marks, French francs, Dutch guilders, and so on needed tomeet payments in those specific currencies will, to some extent, be-come unnecessarily large under the single currency. Thus, adding upall the current payment flows in n currencies will render transactionsbalances redundant. Putting aside the question of whether the concen-tration of deposits in the mark implies that the consolidation hasalready occurred to a substantial extent, there remains the question ofthe monetary implications of any economizing on these balances. Inparticular, it is not clear that these balances entail much of a demandfor base money. For instance, possibly reservable foreign holdings ofdeutsche mark bank deposits in Germany are much smaller thanforeign holdings of deutsche mark bank deposits in Luxembourg,London, and elsewhere abroad.18 Again, a monetary policy that fixes

18 More precisely, nonresident nonbank holdings of marks in Germany, which mayrequire the holding of reserves, are smaller than the holdings of marks outside Germany

22

the repurchase rate should permit adjustment in these balances withoutturmoil in the money market.

More difficult might be the market’s reading of foreign-exchange

by non-German resident nonbanks ($96 billion as compared to $133 billion); see BIS(1997a, pp. 11, 13, and table A.5.1).

policy per se. It is particularly difficult to judge ahead of time hownational differences in the importance attached to exchange-rate stabil-ity will work out in practice. If the ECB’s directors are not of onemind on this matter, market expectations could be quite volatile. Thereis the question, moreover, of the role of the political authorities inforeign-exchange-rate policy.

Kenen (1995, p. 123) has argued, in addition, that an ECB single-mindedly focused on domestic stability might eschew internationalcoordination to limit dollar/euro exchange-rate volatility:

The ECB will want to earn credibility by proving its ability to maintainprice stability. Hence it may resist EC involvement in any attempt atexchange rate management by the G–7 countries, especially if it were seento require heavy intervention on the foreign exchange market.

Volatility in the early years of the ECB might also arise if somecountries do not join monetary union in the first round. Both DeGrauwe (1996b, p. 21; 1997) and Spaventa (1996, p. 54) predict highervolatility between the euro and the excluded currencies, althoughSpaventa limits his prediction to the case in which an effective ERM IIis not put in place. It is hard to imagine that intra-European volatilitywould not induce volatility in the dollar/euro exchange rate.

Summary

The early years of the ECB may see portfolio reflows toward the euro.Private market participants may anticipate a tilt toward a firmer interest-rate policy and a bias against euro depreciation during a period inwhich the ECB is consolidating its credibility. Central banks will enjoyin short order the opportunity to invest in a liquid market for high-quality treasury bills denominated in euro. Monetary-policy operationsconducted in a variety of markets may of necessity adopt a transparentprocedure that avoids leaving private market participants guessing atthe ECB’s intentions, with implications for money-market volatility andknock-on effects in the bond market and foreign-exchange market.Still, the inevitable process of defining the new central bank’s foreign-exchange policy could prove a source of market volatility.

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4 Toward the Steady State

The steady-state role of the euro in relation to the dollar and yen is asubject that attracts more attention than it produces consensus. In theearly 1970s, at the beginning of the period of general floating, Triffin(1973, p. 78) foresaw that the “Community’s unit of account would alsobe likely to be used more and more, in lieu of the Eurodollar, inprivate lending and borrowing operations.” A generation later, however,Kindleberger (1996, pp. 187–188) noted that “the surprise in thishistory is that . . . there was no general revulsion against lending indepreciating dollars. . . . The world stayed with the dollar as a limpingstandard faute de mieux.”19 The “640 billion euro” question is whetheroffering a heavy-weight alternative to the “limping standard” will attracta large net portfolio shift from the dollar.

In the steady state, four slowly evolving developments could bear onthe level and volatility of the dollar. First, the size of the euro areacould lead to a wider use of the euro as an anchor for the exchangerates of smaller countries. Second, the increase in the liquidity of thefinancial markets denominated in euros could affect the behavior ofprivate portfolio managers. Many analysts stop at this point and concludethat the euro will attract a large net portfolio shift from the dollar. Butmore anchoring to the euro and more liquid euro financial markets couldalter the choice of currency denomination made by debt managers, athird development, which is discussed below. Fourth, unified Europeanexchange rates could increase effective dollar volatility even if thedollar/euro rate were no more volatile than the historical dollar/markrate. Moreover, a possible waning of concern about exchange-ratemovements in European policymaking could raise the volatility of thedollar/euro rate relative to the historical dollar/mark rate.

The Euro as an Anchor Currency

Some observers imagine that the euro, backed by the world’s largestsingle economy, could provide an anchor for a broad range of countriesoutside the euro area proper. With currencies linked to the euro,private traders might increasingly denominate their transactions in theeuro, a practice that would lead them to hold working balances ineuros and would ultimately reinforce any tendency for private and

19 Or as de Boissieu (1996, p. 130) puts it: “Since the end of the 1960s . . . the dollarhas been challenged without being replaced.”

24

official portfolios to shift into the euro. Let us consider the euro as ananchor currency, starting with the countries nearest to the prospectiveeuro area and working outward from there.

The linkage of Central and Eastern European currencies to the eurolooks likely to many observers (Alogoskoufis and Portes, 1992,pp. 277–278; Arrowsmith and Taylor, 1996, p. 21; Berrigan and Carré,1997; Frenkel and Goldstein, 1997). Already, daily movements of theHungarian forint, Polish zloty, and Czech koruna against the dollarshare about half of the deutsche mark’s movement (Figure 7). Similarly,official reserves and foreign debts appear to be divided roughly half-and-half between the two largest reserve currencies. Close trade andinvestment links between Eastern and Western Europe suggest theappropriateness of a euro anchor (Bénassy-Quéré, 1996b, pp. 42–44).Some observers suggest that the introduction of the euro and foresee-able progress on EU accession by Central European countries couldlead to the pegging of the forint, zloty, Czech koruna, and Slovakkoruna to the euro, perhaps as part of some ERM II (Backé andLindner, 1996). The Czech authorities have indicated that they plan topeg the koruna to the euro when it comes into existence (Thorpe et al.,1997, p. 179).20 Moreover, in June 1997, the Bulgarian authorities,struggling to stabilize the lev, chose to peg it to the mark (at 1,000 to 1,making life easy for Italian tourists in Sofia). Continuation of this trendwould replace a zone of hybrid currency pegs in Central Europe with aeuro zone (Table 6).

This development could expose the trade between the broad euroarea and the successor states of the Soviet Union to movements of thedollar/euro exchange rate. Under these circumstances, the dollarorientation of the ruble might come into question. One can imaginethe ruble following the path of the zloty, which overcame very highinflation with the help of a dollar peg but was then switched to ahybrid peg in May 1991 (Radzyner and Riesinger, 1996; Koch, 1997),and may eventually be pegged to the euro. Although trade with theeuro area would tend to induce the Russian authorities to peg theruble to the euro, inertia, trade with Asia and the Americas, and theimportance of Russia’s commodity exports would all work to keep theruble anchored to the dollar. Inertia favors the dollar because the rubleis currently managed against the dollar and tens of millions of hundred-

20 Unsurprisingly, the Estonian kroon, currently worth 12.5 pfennig, is to be fixed tothe euro; see Thornhill, 1997.

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TABLE 6

EXCHANGE-RATE REGIMES AND POLICIES IN CENTRAL EUROPE

Country Regime BasketFluctuationBands Stability

Bulgaria Currencyboard

DM — Started July 1, ’97

CzechRepublic

Managedfloat(peg fromJan. ’91to May ’97)

DM(45%DM, 31%$,12%Sch, 7%SF, 4%£from Jan. ’91 to May’93; 65%DM, 35%$until May ’97)

None(±0.5% fromJan. ’91 toFeb. ’96; ±7.5%until May ’97)

Peg successfullyattacked May ’97

Hungary Crawling peg(adjustablepeg beforeMarch ’95)

70% DM, 30% $(’91 to July ’93:50% ECU, 50% $; untilAug. ’94: 50% DM,50% $; until Jan. ’97:70% ECU, 30% $)

±2.25% 1.4% devaluation inJan. ’95; 2% in Feb.’95; 9% in March ’95;then automatic monthlydevaluation rate of1.9% until June ’95;1.3% until Dec. ’95;1.2% in ’96; 1.1% in ’97

Poland Crawling peg($ peg fromJan. ’90 toMay ’91)

45% $, 35% DM10% £, 5% FF,5% SF

±7%(±0.5% untilMarch ’95;±2% untilMay ’95)

14% devaluation inMay ’91, 11% in Feb.’92, 7% in Aug. ’93;automatic monthly de-valuation of 1.8% fromOct. ’91 to Aug. ’93,1.6% until Sep. ’94,1.5% until Nov. ’94,1.4% until Feb ’95,1.2% until Jan. ’96, 1%since; in addition, 6%revaluation in Dec. ’95

SlovakRepublic

Fixed peg 60% DM, 40% $since July ’94

±5%(±1.5% untilDec. ’95; ±3%until July ’96)

Stable against the bas-ket since 10% devalua-tion in July ’93

Slovenia Managed float — — 9% depreciation againstECU between Jan. ’95and Oct. ’96

SOURCES: Backé and Lindner, “European Monetary Union,” 1996; Radzyner and Riesinger,“Exchange Rate Policy in Transition,” 1996; BIS, Handbook on Central Banks, 1997c, extendedand updated by the author.

27

dollar bills circulate in Russia. Trade with Asia and the Americas,presumably conducted in dollars, could prove more dynamic than tradewith Europe if rapid Asian growth persists and the EU agriculturalpolicy proves inhospitable to imports from the east.

The effective dollar anchoring of commodity prices helps to sustainthe dollar orientation of Russian and other commodity producers.Dollar commodity prices are usually more stable than commodityprices expressed in marks, so that Russian oil and gold exports tend toyield a more stable stream of rubles with a dollar anchor for thecurrency.21 Certainly, the dollar price of gold shows much less sensi-tivity to movements in the dollar/mark rate than it did a decade and ahalf ago (Figure 8),22 perhaps because the balance of private demandfor gold has tipped from European investors to nouveaux riches indollar-linked Asia (Murray, Klapwijk, le Roux, and Walker, 1997,pp. 44–45). More generally, if the sensitivity of commodity prices tothe dollar’s exchange rate depends on the fraction of demand outsidethe dollar area (Dornbusch, 1985, pp. 328–334), and the dollar area isgrowing faster than the world in general,23 one may hypothesize thatdollar commodity prices are becoming less sensitive to the dollar’sexchange rate. Thus, the argument for Russia’s anchoring the ruble tothe dollar may be getting stronger.

The discussion of Central and Eastern Europe thus tends to twodifferent conclusions. With the prospect of accession to the EU andthe possibility of joining the monetary union in the next century,Eastern Europe might well enter naturally into the euro’s orbit. Russia,with its Far East and commodity trade, and its current dollar orienta-tion with regard to both exchange policy and private foreign-exchangeholdings, is at least a closer call.

21 The parameter estimate of the elasticity of commodity prices with respect to thedollar’s effective exchange rate estimated at −0.62 by Borensztein and Reinhart (1994),does not contradict this statement. An effective dollar exchange rate is correlated with,but much less variable than, the dollar/mark rate. For evidence that the price of gold ismore stable in dollars, see Murray, Klapwijk, le Roux, and Walker (1997, pp. 9–10).

22 The greater-than-unit elasticity of the price of gold with respect to the dollar/markexchange rate found by Dupont and Juan-Ramon (1996) may reflect the sample period,1972–1991; see also Sjaastad and Scacciavillani (1996).

23 The International Energy Agency (1996, pp. 26–27), projects that the “rest of theworld”—that is, countries outside the Organisation for Economic Co-operation andDevelopment (OECD) and the former Soviet bloc, which currently consumes about30 percent of world oil—will account for 70 percent of the increase in world oil demandbetween 1993 and 2010. Evidence is presented below that the fastest-growing portion ofthis “rest of the world” remains in the dollar zone.

28

Even before the recent currency turbulence in Asia, many econo-mists recommended against the linkage of Asian currencies to thedollar and looked forward to the weaning of these currencies from it.Kwan (1994) concluded that patterns of international trade argue thatthe currencies of Hong Kong, Korea, Singapore, and Taiwan should bepegged to the yen. Eichengreen and Bayoumi (1996) suggested that theyen is a marginally better peg than the dollar for the currencies ofIndonesia, Korea, and Thailand, and a not much worse peg for thecurrencies of several other countries. They suggested that “even HongKong, which has resisted greater flexibility to date, may have to con-template it after the resumption of Chinese control in 1997,” a notionthat the Hong Kong authorities vigorously dispute.24 This analysis,however, does not take into account the fact that other currencies,outside as well as inside Asia, are anchored to the dollar. Most Asiancurrencies have been almost completely surrounded by currenciesanchored to the dollar. This circumstance is recognized by Williamson’s(1996) proposal that Asian countries adopt a common currency basketfor pegging, consisting of something like 40 percent in dollars, 30percent in yen, and 30 percent in marks (then euro).25 The analogythat Eichengreen and Bayoumi (1996) draw between Europe’s move-ment away from the dollar in the 1970s and East Asia’s situation todaydoes not respect an important difference. From the outset of floating,a number of European currencies aligned themselves with the markright away, so that a currency that moved into the mark’s orbit laterwas joining an effective mark zone larger than Germany. In Asia, bycontrast, the yen bloc has just one member.

Hamada (1994, p. 330) asks whether each Asian “country was drivenby a purely economic rationale in its exchange-rate policy. In practice. . . political considerations may have motivated the pegging policy.”This interpretation might suggest an increased willingness to anchor tothe yen with the passage of time, much as Taiwan switched some of itsdollar reserves into yen (Table 5). Taguchi (1994, p. 354), of the Bankof Japan, elaborates on the noneconomic considerations:

24 Yam (1996) labeled the notion that Hong Kong will have to abandon its dollar peg“Myth Number Four.”

25 This sounds like the son of the Special Drawing Right (SDR), the IMF’s hybridbasket currency. The introduction of the euro may provide the opportunity or excuse fora recasting of the SDR. At an IMF conference, Philippe Maystadt (1997) of Belgiumraised the question whether the SDR should be based on only the dollar, euro, and yen.Governments propose but markets dispose, and markets have not embraced the SDR(Eichengreen and Frankel, 1996).

30

To what extent, and at what pace the Japanese yen will become ananchor currency in Asia hinges on many economic and noneconomicfactors: e.g., how intraregional trade and investment will develop, thefuture military presence of the United States in this region, whetherpolitical ties among Asian countries become close and the developmentof the U.S. economy . . . [and, in particular, whether] the US economyremains sound and its inflation rate low.

If there is an argument for putting greater weight on the yen, is theargument getting stronger? Bénassy-Quéré (1996a, p. 19) notes that“there is a trade dynamism between non-Japan, Asian countries, . . .and the role of Japan as a trading partner is declining for most of theother Asian countries.” As long as Asian currencies, apart from the yen,remained anchored to the dollar, this trade dynamism implied that thetide was running against the yen in Asia. Thus, even if the scant weightput on the yen in the management of Asian currencies was out of linewith current trade relations, it was becoming less out of line with thepassage of time. Another reason for anchoring to the dollar was its longdownward trend against the yen. The dollar’s rise against the yen fromthe spring of 1995 to the spring of 1997, however, rendered the dollar-linked Southeast Asian currencies uncompetitive.26 The course of thedollar/yen rate will influence the choice of anchors in the years tocome. Recent currency and banking instability in Southeast Asia raisesthe question of whether dollar anchoring is a thing of the past. Whenthe dust settles, greater flexibility in exchange-rate systems is likely. Thechoice of a different anchor, however, is not a foregone conclusion.27

China presents a particularly interesting case in view of the growthof its economy and trade and the near-term prospect for its currency tobecome convertible and internationally tradable. Three-tenths of itsexports go to the United States, as against about one-fifth to Japan and

26 The observation that the Thais devalued the baht in 1984 (after a period of dollarappreciation) and adopted a basket peg thereafter, only to reduce sharply the weight ofthe yen in their basket in 1985 when the dollar started to fall against the yen, is consis-tent with this reading of the evidence. Another consideration, pointed out by Ueda(1994, p. 356) is that a stable consumer-price index in Japan implies a negative inflationrate for Japanese export prices, “creating strong deflationary pressure on other countries”linked to the yen. This argument is similar to that of Mundell (1993, p. 24), whomaintains that “the deflationary stance of the [European] Community . . . will imposetoo tough a monetary standard for the countries of Eastern Europe to match. They arefar more likely to adopt the easier standard that would be set by modest U.S. rates ofinflation.”

27 See Ilzkovitz (1996) for a skeptical view of the prospects for the internationalizationof the yen.

31

to the EU, whereas over one-fourth of its imports come from Japan, asagainst one-tenth from the United States and one-seventh from theEU. China’s exports and the peg of the Hong Kong dollar to the U.S.dollar are cited by Hong Kong observers as reasons for the likelycontinuation of the anchoring of the Chinese currency to the dollar(Chen, 1997).

As for Latin America, its currencies are anchored to the dollar asstrongly as ever. For some years, the Chilean peso was tied to a basketthat assigned the dollar a weight of less than 50 percent, but as experi-ence showed that dollar import prices did not fall as the dollar rose into1997, the basket was revised to put a more typical weight on the dollar.

In summary, the euro does not face the chaos suggested by formalexchange-rate arrangements, which make floating exchange rates theoverwhelming norm. Rather, the euro will come into existence sur-rounded by a “dollar zone, [which] far from breaking up since thecollapse of the Bretton Woods system, . . . now encompasses theAmerican continent[s], Asia, the Persian Gulf, Australia and NewZealand” (Ilzkovitz, 1995, p. 93). The policies of key countries nowwithin the zone will determine the ambit of the euro.

The use of the euro as an anchor is related to its use in foreign-exchange-market transactions and its use as the currency of invoicingfor international trade flows. Appendix D shows that, upon its intro-duction, the euro will be on one side of half or more foreign-exchangetransactions, whereas the dollar will be on one side in almost all trans-actions. Appendix E considers trade invoicing, arguing that its impor-tance is often misunderstood and overstated. The evidence, such as itis, suggests that the euro will start way behind the dollar as a unit ofaccount for international trade, with little use by third parties outsidethe euro area. In particular, the notion that oil might be priced ineuros seems to ignore the rapid growth of demand in dollar-linkedemerging economies and the political developments in the 1990s.

Private Asset Managers

There is little disagreement that the introduction of the euro will createbroader, deeper, and more liquid financial markets in Europe. Observersdiffer, however, on the prospects for an integrated government bondmarket in the euro area. A full discussion of these prospects can befound in McCauley and White (1997). The briefer review given herefirst highlights the size of the euro money market and swap market,demonstrating that these markets in euros will bulk large in comparisonwith their counterparts in dollars and yen. It then summarizes the

32

evidence bearing on the prospects for an integrated government bondmarket in Europe.

Ranging from an overnight rate, which will be strongly affected by themonetary-policy operations of the ECB, to interbank rates for place-ments lasting from one week to one or two years, a single-referencemoney-market yield curve for euros can be expected. Its liquidity, asmeasured by derivatives transactions, will surpass that of the yenmoney market, even adopting the hypothesis of a narrow monetaryunion and recognizing the current influence of convergence trades(Table 7). A considerable gap will remain between the $40 trillion peryear turnover in euro futures and forwards and the correspondingvolume of dollar transactions, which exceed $100 trillion.

At longer maturities, the most frequently used private interest rateswill be the yields on the fixed-rate side of interest-rate swaps. Thesestandard and liquid prime-name rates extend from two years to tenyears in maturity and already serve as the most important privatereference rates in today’s bond markets. The convergence among theseswap yields for contracts in Belgian francs, German marks, Dutchguilders, and French francs over the past two years (Figure 9) under-lies the forward rates displayed in Figure 2. At the introduction of theeuro, the now nearly identical swap curves will collapse into a singleswap curve.28 This private capital market in euros is also likely to be avery liquid market from its inception. On current evidence, even anarrow monetary union would offer a swap market about as active asthose in the dollar and yen (Table 8). Even recognizing again thatconvergence trades are providing a temporary boost to Europeantransactions, the euro looks set to offer a private yield curve withworld-class depth, breadth, and liquidity.

Those who argue that the government bond market in euros will befractured point to the municipal bond market in the United States,where different states’ bonds offer different yields as a result of widelydiffering credit standings and tax rates.29 Current bond-market pricingand ratings, however, seem consistent with the development of nearlyuniform valuations for certain European governments’ bonds, whichcould then be interchangeably delivered into a futures contract(McCauley, 1996). At present, evidence points to very similar pricing of

28 Illmanen (1997) considers why French franc forward swap rates have traded belowtheir deutsche mark counterparts.

29 The appropriateness of this analogy may be questioned in view of the strongclientele effects created by the state tax codes’ exclusive tax exemption for interest onhome-state municipal bonds.

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TABLE 7

DERIVATIVES TRANSACTIONS IN PRIVATE MONEY-MARKET INSTRUMENTS

IN EUROS, DOLLARS, AND YEN

(in trillions of dollars per annum)

Currency 1995 1996

German markEuro-mark futures (LIFFE) 17.960 24.090Forward-rate agreementsa 2.200 n.a.Euro-mark options (LIFFE) 2.392 3.251

French francPIBORb contracts (MATIF) 15.513 13.818Forward-rate agreements 2.593c n.a.PIBOR options (MATIF) 4.623 3.038

Italian liraEuro-lira futures (LIFFE) 2.459 4.497Forward-rate agreements 0.451c n.a.Euro-lira options (LIFFE) 0.061 0.618

Total mark, franc, liraEuro-mark/franc/lira futures 35.932 42.405Forward-rate agreements 5.244 n.a.Euro-mark/franc/lira options 7.076 6.907

U.S. dollarEuro-dollar futures (CME, SIMEX) 104.125 97.068Federal funds (CBOT) 3.219 3.042Forward-rate agreementsa 4.667 n.a.Euro-dollar options (CME, SIMEX) 22.369 22.238

Japanese yenEuro-yen futures (TIFFE, SIMEX) 45.543 34.475Forward-rate agreementsa 2.518 n.a.Euro-yen options (TIFFE, SIMEX) 0.521 0.714

SOURCES: London International Financial Futures and Options Exchange(LIFFE); Marché à Terme International de France (MATIF); ChicagoMercantile Exchange (CME); Singapore International Monetary Exchange(SIMEX); Chicago Board of Trade (CBOT); Tokyo International Finan-cial Futures Exchange (TIFFE); BIS, Central Bank Survey 1995; BIS andauthor’s estimates.

NOTE: Yen, mark, franc, and lira amounts are converted at year-averageexchange rates.

a Estimated as average daily turnover in April times 255.b Paris interbank offer rate.c Estimated as mark forward-rate agreements (FRAs) times the ratio of

FRA trading in Paris or Milan to FRA trading in Frankfurt.

34

TABLE 8

TRANSACTIONS IN INTEREST-RATE SWAPS AND SWAPTIONS IN EUROS,DOLLARS, AND YEN

(in trillions of dollars per annum)

CentralBank Surveya

International Swaps andDerivatives Association

Currency 1995 1995 1996b

German mark 1.948 — —Swaps 1.661 0.985 1.935Swaptions 0.287 — —

French franc 2.303 — —Swaps 1.879c 1.113 1.550Swaptions 0.424d — —

Italian lira 0.427 — —Swaps 0.367c 0.217 n.a.Swaptions 0.060d — —

Total mark, franc, lira 4.678 — —Swaps 3.907 2.315 3.485Swaptions 0.771 — —

U.S. dollar 5.981 — —Swaps 4.283 2.856 3.690Swaptions 1.698 — —

Japanese yen 4.904 — —Swaps 4.378 2.259 3.128Swaptions 0.527 — —

SOURCES: ISDA; BIS, Central Bank Survey 1995; BIS and author’s estimates.a Estimated as average daily turnover in April times 255.b First half, at annual rate.c Estimated as mark swaps times the ratio of ISDA-reported French franc

swaps or ISDA-reported Italian lira swaps to ISDA-reported mark swaps.d Estimated as mark swaptions times the ratio of swaption transactions in

Paris or Milan to such transactions in Frankfurt.

the creditworthiness of Dutch, French, and German governmentbonds. In particular, the gap between the nearly identical swap ratesand the respective government-bond yields is practically the same inthe three markets (Figure 10). Never in the history of the swap markethas this spread been so similar for so long across so many markets.30

This observation suggests that the euro-denominated debt of these

30 The spread reflects not just the relative creditworthiness of the respective govern-ments, but also cyclical factors, such as the strength of construction spending (Brown,1989).

36

come to enjoy trading opportunities in all major time zones, similar to

TABLE 9

DERIVATIVES TRANSACTIONS IN LONG-TERM GOVERNMENT SECURITIES

IN EUROS, DOLLARS, AND YEN

(in trillions of dollars per annum)

1995 1996 Memorandum

Governmentbonds and notes Futures

Exchange-TradedOptions

Over-the-CounterOptionsa Futures

Exchange-TradedOptions

CashTrad-ing

Out-stand-

ings

German bonds 9.090 1.274 0.173 12.388 1.550 16.566 0.727French bonds 3.367 0.954 0.256b 3.452 0.869 1.658 0.490Italian bonds 1.610 0.156 0.036 2.008 0.340 0.420c 0.391d

Total German, French,and Italian bonds 14.067 2.384 0.465 17.848 2.759 18.225 1.608

U.S. Treasuries 12.374 3.627 0.435 12.011 3.667 35.843 2.547Japanese bonds 15.956 2.163 1.539 12.262 1.824 6.502 1.996

SOURCES: Salomon Brothers; BIS, Central Bank Survey 1995; various futures exchanges; andnational sources.

NOTE: Data on cash-market trading and outstandings are for 1995 and end-1995, respectively.a Estimated as average daily turnover in April times 255.b Estimated as OTC trading in interest-rate options on traded securities in marks times the ratio

of total OTC trading in interest-rate options in Paris or Milan to that in Frankfurt.c Euroclear and Cedel only.d Lira-denominated treasury bonds only; excludes variable-rate notes.

those now available to holders of U.S. Treasuries.In considering the potential for shifts by private portfolio managers

into the euro, a difficult question arises as to whether interest rates ina large euro bond market might show a smaller correlation with U.S.bond yields than current European government bond rates display.31

This is an interesting question, because private portfolio managerswould find the euro bond market particularly attractive if it were tooffer diversification benefits superior to anything available in theconstituent bond markets. Large size and investor diversity couldprovide ballast to a European bond market now exposed to spilloversfrom New York (Borio and McCauley, 1996a, 1996b; Domanski and

31 See also European Commission (1997b). Masson and Turtelboom (1997) simulatethe change in the correlation of returns on short-term instruments only, derivingambiguous results depending on the ECB’s intermediate target. It is well known,however, that returns on short-term instruments are much less correlated than returnson bonds, so this interesting question remains wide open.

38

Neuhaus, 1996).32 The trend toward higher correlations across Europeanbond markets in recent years, however, has not brought any diminutionof the correlation between the German and U.S. markets.

Greater liquidity and depth could increase the demand for bondsdenominated in euros relative to the total demand for bonds in theconstituent currencies, but the scope for a potential reallocation ofprivate portfolios from the dollar to the euro is necessarily extremelyconjectural. One starting point is provided by the shares across G–10currencies of gross domestic product (GDP), trade, foreign-exchangereserves, and international assets, including both international bankdeposits and international bonds (Figure 11). The G–10 members of theEU produce about one-third of G–10 output and would show a slightlysmaller share of international trade net of their EU trade. After asimilar consolidation, however, the share of international assets denomi-nated in euros would be only about one-eighth of the G–10 total. Forthe euro share to match the output and trade shares of the G–10,members of the EU would require a shift of some $0.7 trillion. Thisfigure should not be taken too seriously; the calculation ignores thenonresident holdings of one-quarter of U.S. Treasury securities and alsothe nonresident holdings of about one-third of German public bonds.The figure serves to make the important point, however, that shifts inprivate portfolios could prove to be much larger than any possible shiftsin official reserves. Similar figures are produced on the backs of differ-ent envelopes by Bergsten (1997) and Thygesen et al. (1995).

Central Banks

Two hypotheses about diversification of official reserves away from thedollar by nonindustrial countries may provide an indicative range. Ifdeveloping countries—admittedly a heterogeneous group, but the lackof available data constrains the discussion here—were to follow Taiwan’sexample in its diversification of the last ten years by increasing theirportfolio weight on core Europe to 25 percent, about $85 billion could

32 A contrary view is expressed by Thygesen et al. (1995, p. 126), who write:Confidence in the insulating properties of flexible exchange rates was shattered from thefirst half of 1994 by the transmission of higher U.S. interest rates to Europe at a time whensuch a linkage seemed inappropriate because of different positions in the business cycleon the two sides of the Atlantic. At a time of high uncertainty in the foreign-exchangemarkets, investors appear to compare national interest rates more directly, discountinganticipated, but very uncertain, exchange-rate changes strongly in comparing the yieldon assets denominated in different currencies. . . . A larger market share of the ECU[euro] in international financial portfolios and, hence, more symmetry between the dollarand the ECU [euro] would not really mitigate the problem.

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Swiss franc has tended to appreciate in real terms in recent years, andSwitzerland has the dubious distinction of serving the most expensiveMcDonald’s hamburgers in the world. Yet the fraction of the Swissfranc in official reserve portfolios has fallen from a peak near 3 percentin 1980 to 1 percent in 1996.

Global Liability Managers

Many analysts foresee that portfolio shifts by private investors andofficial reserve managers from the dollar into the euro will drive up theeuro against the dollar and push the euro area from a current-accountsurplus into a current-account deficit (Bergsten, 1997; Alogoskoufis andPortes, 1997). This argument resembles that of Triffin (1960), whoobserved that the growth of world trade meant a growing demand fordollar-denominated bank accounts with which to settle the transac-tions.34 If the only way for these dollars to reach the hands of tradersoutside the United States were for the latter to run deficits, Triffinargued, then the necessary succession of deficits would undermine thecredibility of the link between the dollar and gold. Take away theproblem of the gold link, and the line of reasoning put forward byBergsten and by Alogoskoufis and Portes is very Triffinesque: a portfolioshift into the euro entails deficits for the euro area.

Kindleberger (1965) and Kindleberger, Despres, and Salant (1966)denied Triffin’s claim that the United States had to run deficits in anyreasonable sense of the word in order to provide the world with dollarbalances. If the U.S. banking system were to extend long-term creditsto foreign companies and governments, and the funds were to accumu-late as short-term bank deposits, then the needs of trade could bemet.35 In application to the present case, the shift of private assetmanagers and official reserve managers into the euro need not pushthe euro upward in the exchange market or push the euro area intocurrent-account deficit if willing borrowers of euros come forward.

This is likely because, in addition to having strong attractions for assetmanagers, a more integrated bond market in Europe would also attractdebt managers in the steady state. (Debt management does not fit into

34 I am indebted for this parallel to Paul De Grauwe, commenting at a Centre forEconomic Policy Research seminar on exchange-rate policy for the euro.

35 Although it is tempting to say that “Triffin had the better of the argument” (Garber,1996, p. 2), it is fairer to say that “the cogency of that position [of Kindleberger, Despres,and Salant] has been thoroughly undermined by the fact that the United States has nowdeveloped a real [that is, a current-account] deficit” (Kindleberger, 1985, p. 295).

41

the above sections because the arguments apply to both official andprivate debt managers.) The development of a broad and deep eurobond market could potentially affect debt management more stronglythan asset management, and the greater supply of euro-denominatedassets could put downward pressure on the euro.

It may seem strange that something as welcome as the developmentof broad, deep, and liquid markets could adversely affect the currencyconcerned, but portfolio theory holds that the shift of funding fromone currency to another will result in some combination of a higherinterest rate and a lower exchange rate for the currency experiencingthe increase in asset supply. For instance, were Korea to issue newdeutsche mark securities and to use the proceeds to buy in all its dollardebt, private investors would need to be induced to hold more markand fewer dollar assets. Depending on the size of the operation, somecombination of higher deutsche mark interest rates and a lower markexchange rate might be required to make the investors willing to holdnewly supplied deutsche mark securities. A flow model of exchange-rate determination agrees with the result: as the Koreans exchanged thenewly borrowed deutsche marks for the dollars required to pay off theiroutstanding dollar debts, the demand for dollars would rise. The currentchoice of currency for large issues by global debt managers and thecurrent financing habitat of emerging economies make the prospect ofheavier use of the euro by debt managers plausible.

The relation of the size of international bond issues to the choice ofcurrency denomination suggests that more-liquid European bondmarkets might attract more borrowing. As matters stand, internationalbond issuers favor the dollar for large deals (Table 10). If an under-writer of a large bond issue in euros could more easily hedge againstmovements in the underlying euro yields by shorting large blocks ofEuropean government bonds, issuing costs might fall, eliminating thisbias and inducing more issuance in euros. Although there is no guaran-tee that borrowers do not offset any constraint on their choice ofcurrency for large debt issues by appropriately managing their otherliabilities and assets, including those off balance sheet, the evidencesuggests that market fragmentation in Europe might be keeping debtout of the euro’s predecessor currencies.

With a broader, deeper, and more liquid bond market in Europe,moreover, debt managers outside Europe could be interested in in-creasing the proportion of their debt that is denominated in euros. Theestimated currency composition of international debt (Table 11) owedby countries in Asia and Latin America shows a very low share of

42

European currencies.36 Even if the euro—or in Asia, the yen—does

TABLE 10

INTERNATIONAL SECURITY ISSUES BY SIZE AND CURRENCY

FROM 1990 TO 1995(in billions of U.S. dollars)

Currency ofDenomination

Less than$1 bn.

Greater orEqual to $1 bn. Total

Developing countries 141.7 10.5 152.2U.S. dollar 96.8 7.4 104.2EU currencies 17.6 0.0 17.6Japanese yen 27.3 3.2 30.5

Industrial countries 1,555.7 209.1 1,764.8U.S. dollar 554.9 119.5 674.4EU currencies 660.1 58.9 719.0Japanese yen 340.8 30.6 371.4

International institutions 117.1 39.9 216.9U.S. dollar 34.1 15.0 49.1EU currencies 113.9 15.3 129.3Japanese yen 29.1 9.5 38.6

Total 1,874.5 259.5 2,134.0U.S. dollar 685.8 141.9 827.7EU currencies 791.6 74.3 865.9Japanese yen 397.1 43.3 440.4

Grand total, includingoffshore centers 2,078.6 276.9 2,355.5

SOURCES: Euromoney Bondware and BIS.NOTE: Includes bonds and medium-term notes.

not displace the dollar as a reserve currency, there is great scope foradditional borrowing in euros.37 Currently, the weight of the Europeancurrencies in the reserves of nonindustrial countries (Table 5) isnoticeably heavier than in the debt of those countries.

36 Table 11 combines data collected by the World Bank and BIS. Compare Bénassy-Quéré (1996a, 1996b), who relies on World Bank data alone.

37 Small EU countries such as Ireland and Portugal may be tempted to borrowexclusively in the broad and deep euro market, instead of using marks, dollars, and localand other currencies. For some EU countries, such a policy might miss an opportunity touse debt management as a substitute for exchange-rate flexibility. If a country has largerthan EU-average trade shares with the dollar area, it is more exposed to a loss of exportsresulting from a dollar depreciation. Whereas before, the tendency of the currency to fallagainst the mark served to buffer the economy against dollar depreciation, going forward,the economy could benefit from the interest savings on dollar-denominated debt in theevent of dollar depreciation. Working in the opposite direction, it must be admitted,

43

It is thus possible that a larger supply of euro-denominated assets,

TABLE 11

CURRENCY COMPOSITION OF DEVELOPING-COUNTRY DEBT AT END OF 1996(in billions of U.S. dollars and percentages)

ObligorU.S.

Dollar %Japanese

Yen %EU Cur-rencies % Othera % Total %

Latin America 421.1 (67.4) 66.0 (10.6) 72.0 (11.5) 65.2 (10.4) 624.3 (100.0)To banks 100.3 2.2 7.1 4.2 113.7To World Bankb 320.8 63.8 65.0 61.0 510.7

Asia 344.7 (46.3) 243.4 (32.7) 71.7 (9.6) 85.4 (11.5) 745.1 (100.0)To banks 135.7 80.1 10.6 16.9 243.3To World Bankc 209.0 163.3 61.1 68.5 501.9

Eastern Europe 138.0 (37.0) 42.6 (11.4) 101.9 (27.3) 90.9 (24.3) 373.4 (100.0)To banksd 7.3 0.5 14.3 5.3 27.4To World Banke 130.8 42.2 87.5 85.6 346.1

Totalf 1,044.5 (50.2) 377.1 (18.1) 329.4 (15.8) 331.4 (15.9) 2,082.5 (100.0)To banks 245.0 73.9 32.9 22.3 374.1To World Bank 799.5 303.2 296.6 309.1 1,708.4

SOURCES: World Bank and BIS.NOTE: World Bank figures for 1996 are preliminary and refer to debt maturities greater than

one year. Multiple-currency debt reported is distributed among underlying currencies according tothe composition of the World Bank currency pool. Obligations to banks exclude bank claims ofmore than one-year maturity, including medium-term debt with remaining maturity of less thanone year. Semiannual maturity distribution is applied to quarterly currency distribution. Includesauthor’s estimates of currency breakdown of debt to banks in offshore centers and other debt tobanks for which no official currency breakdown is available. Figures are rounded and may notsum to totals.

a Includes unidentified.b Includes Caribbean.c Includes East Asia, Pacific, and South Asia.d Includes former Yugoslavia.e Includes Europe and Central Asia.f Includes Africa.

which on portfolio-balance reasoning would push down the value of theeuro, could outweigh a larger demand, which would push it up.38 At

is the new World Bank policy of offering its borrowers a choice in the denomination ofcredits. Previously, the World Bank mixed a currency cocktail, heavily weighted towardlow-interest-rate currencies in Europe and the yen, and it gave its borrowers no choicebut to accept the cocktail. Evidently, the World Bank will be lending a larger share ofdollars under the new policy. I am indebted to Jeffrey Shafer for pointing out this“dollar-negative” factor to me.

38 See Alogoskoufis, Portes, and Rey (1997) for the argument that the shift of assetsinto the euro should be expected to occur faster than the offsetting shift of liabilities.Their argument ignores the importance of short-term international debt and the capacityof currency swaps to transform exposures.

44

any rate, one should not attempt to calculate the effects of the greaterattraction of the euro for official and private asset managers withoutconsidering that it might exert a similar attraction for debt managers.

Volatility

The question of the long-run effect of monetary union on the volatilityof the dollar breaks into two issues: the volatility of the bilateraldollar/euro rate as compared with the historical volatility of thedollar/mark rate and the volatility of the effective dollar rate, that is,the average volatility of the dollar against the currencies of U.S. tradingpartners, each weighted by the importance of its trade.39

An often-heard view is that altered constraints on European mone-tary policy will leave the dollar more volatile against the euro than ithas been against the mark. That is, many observers predict that, in thelong run, the ECB will attach little importance to stabilizing the euro’sexchange rate, pursuing, instead, a policy sometimes called “benignneglect.” The argument starts with the observation that the euro areawill be more closed than its constituent national economies, with aratio of imports to domestic product in the neighborhood of one-tenth,as in the United States and Japan. Prices in the large euro area, poten-tially including currencies pegged to the euro, will therefore be lessinfluenced by foreign prices as translated by the exchange rate. As aresult, a given appreciation or depreciation of the euro will exert lessdeflationary or inflationary force, and the need to adjust interest ratesto counter such force will be reduced accordingly (Kenen, 1995,pp. 122–123; Begg, Giavazzi, and Wyplosz, 1997, p. 15).40

This argument, in its bald form, ignores the considerable cohesion ofEuropean currencies in the face of dollar movements, which meansthat the single-currency result has already been approached to varyingdegrees. When that cohesion was severely strained in 1995, however,the dollar’s depreciation passed through to an unusual extent into aneffective appreciation of the mark, with unusually powerful effects onGerman exports and investment spending. Not just a weak dollar, butalso weak European currencies against the mark, dampened activity inGermany and prompted interest-rate cuts.

39 An intermediate question is how dollar/euro volatility might compare with dollar/ECUvolatility. Thygesen et al. (1995, p. 129) suggest that volatility and cycles in the former willbe larger than volatility and cycles in the latter, but their reasoning is not clear.

40 See Martin (1997) for a treatment of this argument in the context of two countrieswith interacting policies.

45

The benign-neglect story might therefore be better phrased in thefollowing fashion: Monetary union might reduce the policy salience ofthe exchange rate because dollar weakness will no longer be associatedwith European currency strains. Indeed, a weakening dollar has gener-ally preceded realignments within Europe (Figure 3), most spectacularly,but by no means uniquely, in 1992, when the German economy neededthe cooling-off of a strong mark, but the British and Italian economiesdid not.41 With monetary union, European central bankers mightspend fewer weekends worrying about the dollar’s exchange rate.

Two policy counterarguments point in the opposite direction, however,suggesting that a dollar/euro exchange rate may be less volatile thanthe dollar/mark rate has been. The first is the implication of the widerdomain of monetary policymaking in Europe after currency union(Dornbusch, Favero, and Giavazzi, 1997; Kenen, 1997). Interest-ratepolicy under the single currency will presumably respond, not tobusiness conditions in one country, but rather to conditions in a large,possibly more heterogeneous, euro area. Whereas demand pressures inGermany might call for a sharp change in interest rates, conditionselsewhere might require no change at all. Recall the case of Germanreunification. Had the ECB been in existence, interest rates would nothave climbed so high (quite apart from any national differences in toler-ance of inflation). Given policy set with an eye to stabilizing activity inthe euro area as a whole, the amplitude of European interest-rateswings from the trough to the peak of the European business cycle canbe expected to be smaller.42 In fact, before the 1990s, the output gapof the EU as a whole swung less widely than did the output gap forGermany, suggesting the potential for a more stable European interest-rate policy than the observed German policy (Figure 12).43 Becausethe EU cycles and the U.S. cycles were no more out of synchronicitythan were the German and U.S. cycles, there is reason to expect thedollar/euro rate to prove more stable than the dollar/mark rate.

41 Figure 3 transforms the chart in Giavazzi and Giovannini (1989), recently updatedby Buiter, Corsetti, and Pesenti (1997), into a “spider” diagram.

42 See Masson and Turtelboom (1997) for a simulation with a very strong result in thisdirection. Artus (1996) argues that monetary policy will have to be more restrictive torespond to a given inflationary threat, however, because, given the size of the euro area,the effect of a stronger euro on domestic prices will be weaker than the effect of astronger mark on German prices.

43 For evidence of central-bank responses to the output gap, see Clarida, Gali, andGertler (1997).

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union in Europe, which will effectively raise the correlations of a group

TABLE 12

VOLATILITY OF NOMINAL EFFECTIVE EXCHANGE RATES

(annual averages, in percentages)

Country 1983a–96 1993–94 1995–96

Belgium 2.5 3.0 2.6Netherlands 2.8 2.6 3.0France 2.9 2.8 3.0Denmark 3.0 3.2 2.7Spain 3.3 4.6 3.1Germany 3.4 3.7 3.9Canada 3.5 4.4 4.1Italy 3.7 5.4 6.3Sweden 3.9 6.8 5.6United States 4.7 4.2 3.8United Kingdom 5.2 4.9 4.3Japan 6.4 7.2 7.4Australia 7.5 8.0 7.1

SOURCE: BIS.NOTE: Volatility is measured as the annualized standard

deviation of daily percentage changes in nominal effectiveexchange rates calculated over a calendar month. Nominaleffective exchange rates are based on trade flows in manu-factured goods among twenty-five countries.

a October through December.

of dollar exchange rates to unity, will render the effective dollar ratemore volatile, other things being equal.44 If the dollar/euro exchangerate is no less volatile than the dollar/mark exchange rate has been, it isfairly likely that the effective dollar rate will be more volatile with asingle currency in Europe. This statement is close to a tautology, but itgains some support from observations of the dollar’s effective volatilityover the last generation.

Going beyond theoretical analyses of the prospective volatility of theeuro (Bénassy-Quéré, Mojon, and Pisani-Ferry, 1997; Cohen, 1997),consider the “natural experiment” represented by observations of thevolatility of the effective dollar rate in periods defined by the differentdegrees of cohesion among European currencies. The effective dollarrate has generally been more volatile since European currencies moved

44 Thus, a conclusion that the EMS had no effect on the dollar’s volatility cannot bedrawn by examining the volatility of the bilateral exchange rates between the dollar andeach European currency without regard to the covariances; see Edison and Kole (1994).

48

into the deutsche mark’s orbit in the late 1970s.45 The effective dollar’svolatility averaged about 9 percent during the narrow-band period from1979 to 1992 and reached even higher levels during the “hard” ERMperiod from 1987 to 1992. Since September 1992, this volatility hastended to fall, and it has averaged about 7 percent since the wideningof the ERM bands in the summer of 1993 (Figure 13). In short, thevolatility of the effective dollar rate was highest when European rateswere most cohesive, is middling now with generally wide bands, andwas lowest before the ERM.46 Looking forward, monetary union islikely to take the dollar’s effective volatility back up to the levels of the1980s.47

Summary

There is no immediate prospect for the euro’s use as an anchor currencyoutside Central Europe and the Mediterranean. Still, a successful eurocould deepen Europe’s financial markets and conceivably make theevolution of European bond prices more independent of developmentsin New York. Both greater depth and better diversification possibilitiescould attract more international investment to the euro. The prospectof substantial portfolio shifts into the euro, however, does not by itselfjustify forecasts that the new currency will appreciate against the dollarover an extended period. Liability managers outside the euro areashould also find attractive the enhanced liquidity and improved diversi-fication possibilities of euro-denominated debt. Thus, in response to ashift in demand, global financial markets are capable of producingeuro-denominated assets through changes in the currency habitats ofinternational borrowers. Even if there are net (ex ante) shifts into theeuro, their impact on the exchange rate could be smaller than isgenerally believed (see Appendix A).

45 Padoa-Schioppa (1985), demonstrating that the EMS had succeeded in mappingout a zone of monetary stability, showed that European currencies experienced lowervolatility in the period from March 1979 to March 1984 than they had in the period fromMarch 1973 to March 1979, whereas the dollar, pound, and yen all experienced highervolatility. Padoa-Schioppa did not entertain the possibility that the cohesion of theEuropean currencies might be connected to the higher volatility of the other currencies.

46 These observations need not contradict the cross-sectional result of Martin (1997,p. 8), who finds that “EMS currencies have a lower volatility with currencies not in theEMS.”

47 In all likelihood, the larger the euro area, the higher the dollar volatility; see Ghironiand Giavazzi (1997) for implications of the size of the euro area.

49

more than the mark’s one-sixth, but less than the combined EU cur-rencies’ one-third. As a reserve currency, the euro is likely to claim ashare of about one-sixth, much the same as the mark, and lower thanthe one-fifth claimed by all EU currencies (including the pound). Interms of international private assets, the euro’s likely share of one-seventh would be no higher than the mark’s current share and would behalf of the EU currencies’ joint share. When one compares the euro’sprospective role to the one-third share of the EU G–10 countries inG–10 GDP or international trade, one can readily conclude that theeuro’s economic base would support a larger role of the euro as aninternational money. Add to these comparisons an increase in thebreadth, depth, and liquidity of the European financial markets, withthe possible implication of greater independence of returns in Europeanfixed-income markets from those in New York, and the potential for theeuro as an international money comes into view.

But the very act of monetary union will tend to push up the dollar’sshare on all these measures (Table 13). In the foreign-exchange mar-ket, 92 percent of transactions would have the dollar on one side. Intrade invoicing, the dollar would serve as the currency of contract for59 percent of all transactions. As a reserve currency, the dollar wouldrepresent three-quarters of all holdings. And among internationalprivate assets, the dollar’s share would rise to 50 percent. From oneperspective, the rise of the dollar on these measures is uninteresting,reflecting as it does the merely arithmetic effect of treating the EU asa single monetary area.48 After all, although intra-European foreign-exchange transactions will indeed disappear—to the considerablebenefit of Europeans (Emerson et al., 1992)—a Martian would discernno visible change in economic activity: European trade would continueand might grow faster; European central banks would have domesticassets instead of foreign assets; and European borrowers would continueto sell their bonds to Europeans in other countries (perhaps more so),even if no longer denominated in a foreign currency. From anotherperspective, however, the rise of the dollar’s share on these measurespoints to the limited, regional, success of the mark as a vehicle currencyin foreign-exchange transactions, as an official reserve currency and as

48 But see Eichengreen and Frankel (1996, p. 371), who suggest that “if a larger shareof world reserves is denominated in dollars, network-externality effects may encouragecountries to accumulate even more.” Padoa-Schioppa and Saccomanni (1996, p. 380)play down such transactions costs and conclude that “the demand for dollars as a reservecurrency might indeed be subject to major reversals should policy conflicts emerge andpersist.”

51

a standard of deferred payment. In a world of unbalanced growth, this

TABLE 13

INTERNATIONAL USES OF MAJOR CURRENCIES BEFORE AND AFTER

THE EURO

(in percentages)

Use Currency Before After

Official reservesa EU currencies/euroDollarYen

2469

7

1676

8

International assets EU currencies/euroDollarYen

344012

135315

Foreign-exchangetransactionsb

EU currencies/euroDollarYen

708424

569226

Denomination oftrade

EU currencies/euroDollarYen

3448

5

2259

6Memorandum:GDP as % of G-10 Euro-Area G-10

United StatesJapan

363723

363723

International tradeas % of G-10

Euro-Area G-10United StatesJapan

552313

323420

SOURCES: BIS, Central Bank Survey 1995; Consensus Economics,Consensus Forecasts, August 1996; Hartmann, “The Future of theEuro,” 1996, p. 7 (citing Ilzkovitz, 1995); United Nations (for tradedata); IMF; BIS and author’s estimates.

a Shares are rounded and sum to 100, despite the Swiss franc’s1 percent share.

b Figures represent the turnover in which a given currency appearson one side of a transaction; consequently, the percentages sum to200 (including currencies not shown).

regional focus of the mark as an international money has consequencesfor the prospective role of the euro.

The rapid growth of output and international trade in Asia, its spreadto the larger economies of the region, and the general dollar orientationof Asian exchange-rate policies imply that the dollar area has beengrowing faster that the world economy as a whole. (If the U.S. economycontinues to grow faster than the rest of the G–10 economies, the

52

pattern of growth across the G–10 countries will only reinforce thebroader trend.) To be sure, the introduction of the euro will effectivelyenlarge the European currency zone by eliminating the gravitationaleffects of the dollar on the economies at the edges of Europe (Figure 2).But this enlargement, which may occur in several stages and eventuallyinclude the countries of central Europe, is contrary to the generalmovement in the opposite direction produced by faster growth ineconomies more oriented toward the dollar. Dollar Telephone andTelegraph is installing many new lines in young countries, but EuroTelephone and Telegraph will not, on current trends, enjoy suchcustomer growth after it has finished rewiring central Europe.

Some analysts have therefore discerned signs of a leveling off or evenreversal in the 1990s of the long decline in the dollar’s role (Oppers,1995; Frankel, 1995; Eichengreen and Frankel, 1996), a role that in anycase was subject to overstatement (Kenen, 1983). Changing the meta-phor, the plate tectonics of the global economy, by adding to theeconomic mass of parts of the world where wealth is still measured indollars, may serve to sustain and even to increase the dollar’s role.

Looking further ahead, there is no guarantee that the dollar area willcontinue to grow more rapidly than the world as a whole on the basis ofrapidly growing Asian economies linked to the dollar. By mid-1997,growth prospects had darkened for some Asian countries. The deprecia-tion of Asian exchange rates in the summer of 1997, moreover, put theirdollar anchoring in question and may give rise to a larger role for theyen and the euro.

What needs to be borne in mind, though, is the ambiguity of therelation between the respective international roles of the euro and thedollar, on the one hand, and the exchange rate between them, on theother. Were the euro to figure more importantly in the management ofindustrializing economies currently tied to the dollar, asset managersand liability managers there would be more likely to shift their portfo-lios toward the euro. Because these countries are generally runningcurrent-account deficits and thereby accumulating international debt,however, such a portfolio shift from the dollar to the euro would tendto produce a lower exchange rate for the euro against the dollar.

Thus, however the euro, dollar, and yen stand in relation to eachother as international moneys a generation from now, the best predic-tion is that the exchange rate of the euro will reflect inflation outcomes,growth performance, and long-term developments in net-foreign-assetpositions on both sides of the Atlantic. Over shorter horizons, therelation between business cycles and associated cycles in monetary

53

policy will figure importantly in variations in the dollar/euro rate.Portfolio flows between the euro and the dollar might at times exert apowerful force, but they are unlikely to run so much in one directionthat they predominate in setting the dollar/euro rate.

Appendix A: Quantitative Effects of Portfolio Shifts

This appendix tackles two different aspects of portfolio shifts from thedollar into the euro. First, it considers the implications of shifts fromdollar cash into euro cash holdings by residents of third countries.Second, given ex ante shifts from the dollar by official or private assetmanagers, it asks what order of magnitude of change can be expected inexchange rates.

Effects of Redistributing Seigniorage

When considering the effect of monetary union on the international roleof the dollar, it is important to keep in mind what is not at stake. Onesuch matter is a large flow of seigniorage, the interest savings to theU.S. Treasury that result from the holding by foreigners of hundred-dollar bills. Official reserves bear interest and so do not convey awindfall to the issuing country. (Although U.S. Treasury bills may yieldslightly less owing to the substantial share held by foreign central banks,the roughly 10 percent higher yields paid on private instruments suchas bank deposits mostly reflect liquidity and default-risk differences.)Countries can and do borrow to build up their reserves, so reserveaccumulation need not entail a resource transfer to the reserve-currencycountry. The intermediation margin between dollar borrowing rates andreturns on dollar reserve holdings is determined in competitive markets,and large bank deposits in the United States no longer attract a reserverequirement. This margin, moreover, need not accrue to the nationalsof the reserve-currency country; indeed, a substantial fraction of officialdollar reserves, perhaps one-quarter, appears to be held outside theUnited States (BIS, 1997b, p. 83). Furthermore, foreign branches andagencies in the United States receive some fraction of official dollardeposits. Similarly, the private use of the dollar typically does notconvey seigniorage to the United States.49

Only holdings of dollar cash by foreigners (estimated at more than$200 billion) pay an annual tribute (estimated at $12 billion) in the form

49 For an opposing view, see Tavlas (1991, p. 12).

54

of interest savings (Porter and Judson, 1996; Johnson, 1994). Even thoseanalysts of European monetary union who foresee a significant shift ofthis seigniorage toward the euro have estimated a stream of seignioragemeasured in single-digit billion-dollar figures and have recognized itstiny potential contribution to Europe’s GDP.50 Indeed, when thesubstitution of euro notes for mark notes occurs in the new millennium,there is a risk that the stock of mark notes held outside Germany mightnot be replaced by crisp new euro notes but might instead be put intointerest-bearing bank accounts or even dollar cash. At risk here is acurrent flow of seigniorage to Germany (at 3 percent per annum) ofDM 2 to 3 billion. Note that, despite counterfeiting problems, the U.S.Treasury was careful not to force the exchange of old hundred-dollarbills for newly introduced bills, lest the new Ben Franklin notes notreturn to sterile mattresses, stashes, and safe-deposit boxes.

Effects of Portfolio Shifts

As for the exchange-rate effect of the portfolio shifts described above,a quantitative perspective is useful (see Hung, Pigott, and Rodrigues,1989). The stock of debt issued by the governments of the G–10countries is about $10 trillion. In a somewhat stylized case of $3 trillionof debt in dollars and an equivalent amount in euros, a $30 billion supplyshift from dollars into euros represents about 1 percent of either debtstock. If interest rates do not respond, so that the half-and-half portfoliodemands are not disturbed, the dollar would have to fall by 2 percentagainst the euro to restore portfolio balance. Such an exchange-ratechange is not much more than the standard deviation of one week’smovement in the dollar/mark rate. In this example, moreover, theunderlying asset stock and the exclusion of interest-rate effects both workto increase the hypothetical exchange-rate effect of the $30 billion shift.

50 See Alogoskoufis and Portes (1991, p. 241). Emerson et al. (1992), using an estimateof $100 billion for offshore dollar cash, “guesstimate” that one-third of that amount couldshift into ECUs, which at a 7 percent nominal interest rate, would generate $2.5 billionof seigniorage per year, or 0.045 percent of EU GDP. If one doubles the $100 billion,halves the interest rate, and makes some allowance for the DM 65 to 90 billion estimatedby the Bundesbank (1995, p. 70) to be already circulating in Turkey, Poland, andelsewhere, the seigniorage would remain a single-digit billion-dollar equivalent, makinga 0.0-something contribution to EU GDP. Alogoskoufis and Portes (1992, p. 292) producean estimate similar to that of Emerson et al. Johnson (1996, p. 165) considers the case inwhich $100 billion in euro notes are held outside the euro area. See Rogoff (1997) for adiscussion of the merits and demerits of international competition for seigniorage.

55

Under more realistic assumptions, the long-run effect of even triple-digitportfolio shifts would not stand out in monthly trading, although someshort-run digestion of shifts might be noticeable for a time.

Appendix B: Dollar/Mark Polarization and the Swiss Franc

In February 1996, the head of the Swiss Federal Department forEconomic Affairs asked a commission comprising academics andbureaucrats, with representation of employers, employees, and bankers,to report on the implications of European monetary union for the Swisseconomy. The commission’s (Commission, 1996) view that capital isalready fleeing the euro area into Switzerland has already been notedabove, as has the Bundesbank’s view that no solid evidence exists for thisconclusion. The available data give little hint as to the origins of fundsin trust accounts of Swiss banks, although there are suggestive observa-tions, such as the Wall Street Journal headline earlier this year, stating“More German Banks Are Opening Swiss Units” (Wiesman, 1997). Inany case, the Swiss commission’s report concluded famously with somecontingency planning: if the flight of capital into Switzerland threatenedto push the franc to unbearable heights, the franc could temporarily bepegged to the euro.51 Swiss National Bank authorities have from timeto time repeated this possibility publicly, which is perhaps the monetaryequivalent of letting potential invaders know that dynamite is already setin your tunnels and under your bridges.

A potentially important implication for the Swiss franc, which wasapparently not considered by the commission,52 arises from the histori-cal pattern of exchange-rate changes in conjunction with the scale of thecore European holdings of deutsche mark deposits. A long-observedregularity in exchange markets is that deutsche mark strength againstthe dollar is often associated with weakness of most European curren-cies against the mark (Figure 2). This dollar-mark polarization haspresented a useful risk-reduction possibility for European investors. Fora French investor, for instance, holding deutsche mark assets hasoffered a useful hedge against dollar assets: when the dollar has de-clined against the French franc, the mark has tended to rise. Partly forthis reason, nonbank residents of France, Belgium, the Netherlands,

51 An interesting question is whether Swiss interest rates would rise or fall under thesecircumstances (see Mauro, 1996).

52 Or by Laxton and Prasad (1997), although they may have modeled it as a persistentportfolio-preference shift.

56

and Austria hold mark deposits in London, Frankfurt, and elsewhere(Table B–1). Were European exchange rates to be fixed, this negative

TABLE B–1

HOLDINGS OF MARK, SWISS FRANC, AND DOLLAR BANK DEPOSITS

BY RESIDENTS OF CORE EU COUNTRIES

AT END OF 1996(in billions of U.S. dollars)

CountryGermanMarks

SwissFrancs

U.S.Dollars Total

Germany —a 3.5 17.7 21.2France 9.3 3.5 24.8 37.6Netherlands 53.4 5.1 30.6 89.1Belgium/Luxembourg 23.5 4.2 32.5 60.2Austria 11.8 0.6 3.6 16.0Total Core EU 98.0 16.9 109.2 224.1

SOURCE: BIS.NOTE: Nonbank holdings only.a Deutsche mark deposits made by German residents in non-German

banks amount to $149.8 billion.

covariance would disappear. The Swiss franc would most likely remainas an alternative, however, and it might become more attractive ininternational portfolios as a result of its greater scarcity.53 The Swissfranc tends to appreciate against the deutsche mark when the markappreciates against the dollar. Given this tendency, the worst scenariosin terms of the potential appreciation of the Swiss franc would be onesin which the deutsche mark rises, for instance, a noncredible delay inthe start of monetary union.

If this nexus among dollars, marks, and Swiss francs is expected toreproduce itself, after the start of monetary union, as a nexus amongdollars, euros, and Swiss francs, some potential responses by privateinvestors merit consideration. Some of the $98 billion equivalent ofdeutsche mark bank accounts held by the residents of core Europeancountries might be reinvested in the Swiss franc. To date, most of the

53 Eichengreen (1992, p. 58), suggests that “following EMU, investors in countries likeFrance will have most of their wealth denominated in units of the single Europeancurrency. To minimize the risks caused by its fluctuation, they may find it attractive tohold additional dollars.” But the Swiss franc might substitute for the lost services of thedeutsche mark better than would the dollar.

57

reports of EMU-related investment in the Swiss franc have centered onGerman residents redeploying their wealth. Given the disappearance ofa negative covariance in dollar and deutsche mark returns for French,Belgian, Dutch, and Austrian assets, some reallocation of their portfoliosmight be expected.

In the long run, the development of euro financial markets (McCauleyand White, 1997) may reduce the sensitivity of the Swiss franc/euroexchange rate to movements in the dollar/euro exchange rate (ascompared with the sensitivity of the Swiss franc/mark rate to thedollar/mark rate). Following the argument of Galati and McCauley(1997) that the Swiss franc owes its extreme position in the dollar/markaxis to the disproportionate importance of international investment inthe Swiss franc, the internationalization of the euro in comparison withits constituent currencies should lead to better balance between theSwiss franc and the euro, and, thus, to less volatility in their exchangerate. This seems to be the conclusion, and the grounds for reaching it,of the Swiss commission (Commission, 1996, p. 3):

The more stable the Euro becomes and the more liquid monetary andfinancial markets in the EMU are, the more the Euro should establishitself as a currency for international investment, thereby competingagainst the Swiss franc. The risk of an increased volatility of the exchangerate of the Swiss franc resulting from the substantial difference in sizebetween the European monetary zone and Switzerland will decrease.

Appendix C: Resources, Constraints, and Incentives of EuropeanOfficial Reserve Managers

This appendix considers reserve management by European centralbanks in the transition stage and in the steady state and makes plausibleestimates of the current composition of EU reserves. It must be said,however, that foreign-exchange reserves reflect past intervention andthat they can rise or fall unpredictably even over a year or two. Inparticular, they can change markedly in any period of exchange-marketturbulence. That said, should one expect European central banks to sellmarks in the approach to monetary union but to sell dollars in itsaftermath?

Switches into Dollars in the Transition Stage?

In the transition stage, purchases of dollars in the market could occurif participating central banks wished to preserve as foreign-exchange

58

reserves their substantial holdings of deutsche marks and other core

TABLE C–1

THE COMPOSITION OF EU FOREIGN-EXCHANGE RESERVES AT END OF 1996(in billions of U.S. dollars and percentages)

CurrencyCoreEUa %

Core EUw/o

Germany %OtherEUb % Total %

Core EU 33 (23) 33 (45) 92 (45) 126 (36)Other 109 (77) 40 (55) 113 (55) 222 (64)Total 142 (100) 74 (100) 206 (100) 348 (100)

SOURCES: IMF; BIS and author’s estimates.NOTE: Foreign-exchange reserves are calculated as total foreign-exchange

reserves reported by the IMF less one-fifth of gold reserves (at end-September),assumed to have been swapped for ECUs. It is assumed that 45 percent of thereserves of both the core (excluding Germany) and other EU countries are held incore European currencies. “Other” currency is mostly dollars. Components arerounded and may not sum to totals.

a Austria, Belgium, France, Germany, Luxembourg, and the Netherlands (andECUs with respect to currencies).

b Denmark, Finland, Greece, Ireland, Italy, Portugal, Spain, Sweden, and theUnited Kingdom.

European currencies. The scale of these holdings, estimated at $126billion, or a little more than one-third of total EU foreign-exchangereserves of $348 billion at the end of 1996, makes this an interestingpossibility (see Table C–1).54 If dollar weakness does not give thosecentral banks an opportunity to intervene and sell marks against dollars,and off-market transactions are not possible, some portion of the esti-mated $126 billion can be sold on the market this year or next. Thepossible motives for such conversions are by no means obvious. Therules for sharing the seigniorage arising from non-interest-bearing euro

54 Compare Kenen (1995, p. 114), who reports that EU countries held “more than aquarter” of their foreign-exchange reserves in EU currencies in September 1991, accordingto calculations based on unpublished IMF data, and who writes (1996, p. 24) that “thedeutsche mark holdings of EU countries probably account for about 20 percent of EUforeign-exchange reserves and for about 25 percent of the currency reserves of EUcountries other than Germany.” Also see Gros and Thygesen (1992), who put EU foreign-currency reserves held in EU currencies at 40 percent (p. 403) or at 55 percent (p. 254),and Masson and Turtelboom (1997, p. 205), who appear to treat all ECUs as official ECUs.

59

liabilities of the European System of Central Banks (ESCB) couldconceivably provide an incentive to hold dollars from the start of theECB.55 But the incentive might pertain less to income or wealth thanto power: the rules of the ECB could leave the national central banksmore discretion over their (residual) foreign-currency assets than overtheir domestic assets. Sheer uncertainty with respect to either theeconomic or political implications of a central bank’s asset compositionmight also recommend a switch into dollars.

Several considerations, however, render the prospect of large andpossibly disruptive switches into dollars less likely in the near term: thepossibility that some European currencies will remain outside thecurrency union for a time; the attractions of a passive strategy; and thefact that the first round of reserve pooling is unlikely to force sales ofmarks for dollars. If some EU countries were not to join monetaryunion initially, they might well need holdings of marks (and then euros)and might even seek to hold more reserves in core European currencies(or in euros) to back their commitments under an ERM II. This wouldhold especially if these “outs” (or so-called “pre-ins”) were to anticipatethat the market for exchanges of their domestic currencies against theeuro would gain relative to the market for exchanges against thedollar.56

For central banks entering the monetary union, the alternative ofinaction would permit reserves currently held in European currencies tobe transformed into euros and invested in domestic assets. Centralbanks that anticipate an excess of foreign-exchange reserves under thesingle currency (see below) might find this do-nothing strategy attrac-tive. It has been suggested that this course would be compellingbecause, as the reserves become euros, they could be used to retire

55 The intention is to distribute the euro’s seigniorage according to the shares shownin Table C–2. The problem then becomes how to identify the seigniorage. The EuropeanMonetary Institute (1997, p. 77) reports that the method for identifying seigniorageforeseen in Article 32.2 of the ESCB/ECB Statute was to earmark assets correspondingto cash and bank reserves and to pool the actual income earned on those assets. Difficul-ties in harmonizing central-bank accounting, however, have led to work on an alternativemethod, which could be used for up to five years. Under this alternative method, incomewould be imputed to the assets corresponding to cash and bank-reserve liabilities, usingthe monthly repo rate on euros (see “Dispute,” 1997, p. 8). At a time of record lowEuropean short-term rates, a central bank concerned about its income—and skepticalabout the Fisher open-interest-parity hypothesis—might prefer dollar to euro assets.

56 This would reverse the gain in dollar transactions relative to mark transactions shownin exchanges against the lira and British pound between 1992 and 1995 (BIS, 1996b,p. 96). For the link between the currency composition of transactions and the composi-tion of reserves, see Dooley, Lizondo, and Mathieson (1989).

60

government debt (Persaud and Dambassinas, 1996). Strictly speaking,however, any transfer of euros from a central bank to its treasury wouldhave to take the form of a special dividend paid out of the centralbank’s retained earnings.57 As suggested by the dispute over the Ger-man government’s proposal to take into its budget some of the unreal-ized gains on the Bundesbank’s gold holdings, such a special dividendraises questions among some European central banks. After all, theMaastricht Treaty prohibits central-bank financing of governments. Grosand Thygesen make the point that investing the central bank’s formermarks, now euros, in domestic government debt is economically equiva-lent to handing the proceeds over to the government for debt reduc-tion.58 Indeed, the economic effect of shifting former marks (noweuros) out of German government debt and into domestic governmentdebt would be visible only as a small change in the spread between theyield on German government debt and domestic government debt.

It is important to recognize that the first round of reserve pooling bythe European central banks is unlikely to force sales of marks againstdollars. In principle, an EU member having a high proportion of marksin its foreign-exchange reserves could be forced to buy dollars because“only assets denominated in currencies of non-EU Member States andgold will be eligible for transfer to the ECB” (EMI, 1995, p. 57). Butthe numbers suggest that forced sales of marks against dollars areunlikely. Three scenarios for the initial pooling merit consideration(Table C–2).59 In the first, European central banks contribute onlyforeign exchange to the agreed upon initial ECU 50 billion pooling. Inthe second and third scenarios, gold as well as foreign exchange ispooled. (These latter scenarios have some of the flavor of the transac-tions underlying the creation of official ECUs, for which central banksswap a given fraction of their dollar and gold holdings.) In no case doesthe pooling demand a fraction of non-European reserves that is largeenough to force sales of marks for dollars. Of course, further amountscan be pooled after appropriate agreement.

57 Such a payment could also be made out of any gains recorded when mark-denomi-nated reserves become euros (if, for instance, marks were carried at historical values interms of domestic currency on the central bank’s balance sheet) or from a revaluation ofgold holdings.

58 Gros and Thygesen (1992, p. 254) suggest that “from an economic point of view itdoes not matter how these former foreign exchange reserves are used. The net worth ofthe government (aggregating central bank and treasury) does not change when, forexample, foreign exchange reserves are used to retire public debt.”

59 Compare Gros and Thygesen (1992, p. 403), who set out country-by-country reserveholdings of non-EU currencies and compare them with pooling needs.

61

As matters stand, therefore, European central banks are more likely

TABLE C–2

RESERVE POOLING OF ECU 50 BILLION AT THE EUROPEAN CENTRAL BANK AT END OF 1996:THREE SCENARIOS

(in billions of U.S. dollars and percentages)

CountryWeight

(%)

FXRe-

servesa

GoldRe-

servesb

OnlyFX

Pooled

Equal Amountsof FX & Gold

Pooled

Equal Propor-tions of FX &Gold Pooled

Amt. % Amt. % FX % Gold % FX GoldCore EU

Germany 22.6 68.6 35.1 14.0 (20.4) 7.0 (10.2) (19.9) (13.5) 9.3 4.7France 17.0 16.9 30.2 10.6 (62.5) 5.3 (31.2) (17.5) (22.4) 3.8 6.8Netherlands 4.3 21.5 12.8 2.6 (12.3) 1.3 (6.1) (10.3) (7.7) 1.7 1.0Belg/Lux’bg 3.0 14.2 5.7 1.8 (12.9) 0.9 (6.5) (16.1) (9.2) 1.3 0.5Austria 2.3 21.0 4.0 1.4 (6.8) 0.7 (3.4) (17.9) (5.7) 1.2 0.2

Subtotal 49.1 142.2 87.8 30.5 (21.4) 15.2 (10.7) (17.3) (13.2) 18.8 11.6

Other EUItaly 15.9 39.0 24.6 9.8 (25.2) 4.9 (12.6) (20.0) (15.5) 6.0 3.8U.K. 15.4 35.7 6.8 9.5 (26.7) 4.8 (13.4) (70.1) (22.4) 8.0 1.5Spain 8.9 54.7 5.8 5.5 (10.0) 2.7 (5.0) (47.4) (9.1) 5.0 0.5Sweden 2.9 17.8 1.8 1.8 (10.1) 0.9 (5.1) (50.0) (9.2) 1.6 0.2Greece 2.0 17.0 1.3 1.2 (7.3) 0.6 (3.7) (47.8) (6.8) 1.2 0.0Portugal 1.9 14.2 5.7 1.1 (8.1) 0.6 (4.0) (10.1) (5.8) 0.8 0.3Denmark 1.7 13.3 0.6 1.1 (7.9) 0.5 (4.0) (88.0) (7.6) 1.0 0.0Finland 1.7 6.1 0.6 1.0 (16.8) 0.5 (8.4) (85.4) (15.3) 0.9 0.0Ireland 0.8 7.7 0.1 0.5 (6.5) 0.2 (3.2) (248.4) (6.4) 0.5 0.0

Subtotal 51.0 205.5 47.3 31.6 (15.4) 15.8 (7.7) (33.4) (12.5) 25.7 5.9

Total EU 100.0 347.7 135.1 62.1 31.1 44.6 17.5

SOURCES: IMF; BIS and author’s estimates.NOTE: Weights are taken from EMI, Annual Report 1994, p. 71. Components are rounded and

may not sum to totals. At the end of 1996, one ECU was worth $1.242.a Foreign-exchange (FX) reserves are calculated as total FX reserves at end of 1996 as reported

by the IMF less one-fifth of gold reserves (at end-September), assumed to have been swapped forofficial ECUs.

b Market values at end of 1996.

to buy dollars for the purpose of maintaining reserve holdings than forthe purpose of pooling. Given the market attention paid to their actions,however, shifts by any European central bank out of marks into dollarsare likely to remain modest. Moreover, European central banks notinvolved in the initial union, but with commitments under an ERM II,could desire more marks and be prepared to buy some off-market.

Excess Dollars in the Long Run?

After monetary union, European central banks may find that they havemore dollars than they need. Emerson et al. (1992) put the excess of

62

reserves at between $200 and $230 billion, but Kenen (1995, p. 115)shows that such figures imply excess dollar holdings of something like$40 to $70 billion. Gros and Thygesen (1992, p. 254) use U.S. reservesas a benchmark to suggest excess reserves of about ECU 50 billion atone point in their discussion (p. 254) but swing back past the questionfurther on and use unpooled reserves to suggest excess reserves ofECU 80 billion (p. 403).60 The excess of reserves over each country’sshare of the ECU 50 billion (Table C–2) cannot be taken as the measureof this surplus, however, because calls beyond the ECU 50 billion canbe made in the future. Unpooled reserves left at the national centralbanks, moreover, are not necessarily useless. Some countries, includingAustria, Belgium, and Italy, have dollar debt outstanding. Furthermore,national central banks could conceivably carry out foreign-exchangeintervention as long as they act “under instructions from the ECB.”61

One crude but very popular benchmark against which to measure thepotential excess is the shrinkage of EU members’ international trade byabout 60 percent when intra-EU trade ceases to be international. Thefraction of EU members’ trade with each other, however, is shrinkingbecause their trade is expanding most rapidly (albeit from a low base)with fast-growing countries whose currencies are anchored to the dollar.One can imagine that EU countries would desire to reduce theirinternational-reserve holdings by something like one-half. But it shouldbe recalled that EU reserve holdings denominated in core EU currenciesamount to one-third of total holdings. If this fraction of internationalreserves is allowed to become euro-denominated assets, EU countrieswill already have lost one-third of their total reserves. Given thispotential for passive reserve reduction, active reserve management inEurope might yield a reduction of one-sixth in current reserves, orabout $55 billion.62 Most analyses of this question by economists atbanks and securities firms have taken something like this approach(Table C–3).

60 Could the inconsistency have arisen from different treatments of the dollars“swapped” for official ECUs, more a nominal than a substantial transaction?

61 See EMI (1996, p. 56), based on Article 31 of the ESCB/ECB Statute requiringECB authorization for the foreign-exchange operations by national central banks.

62 Golden (1996) and Parsons (1996) report different numbers using this same tradebenchmark, whereas Brookes (1996) uses current ratios of reserves to imports forindividual EU countries in recognition of the wide range of observed ratios: from 0.8months’ imports for France, through 3.4 for the EU on average, to a high of 7.0 forGreece. Keating’s (1996) approach has much to recommend it. He uses the United Statesas a benchmark but measures U.S. reserves against U.S. trade with the nondollar area.

63

The trade benchmark is, however, an anachronism, a vestige of

TABLE C–3SURPLUS FOREIGN-EXCHANGE RESERVES OF EURO AREA: VARIOUS RECENT ESTIMATES

(in billions of U.S. dollars)

Surplus

Source Core EU Other EU Total EU Benchmark

CS First Boston(Keating, 1996) None

Ratio of U.S. reserves to tradewith nondollar area

JP Morgan(Persaud andDambassinas, 1996) 30–70

Average ratio of reserves to im-ports for 23 industrial countries

Goldman Sachs(Brookes, 1996) 30 93 123

1994 ratios of reserves to importsfor individual EU countries

Paribas(Parsons, 1996) None

Current aggregate ratio of re-serves to imports for the EU

Nomura(Golden, 1996) 100

Current aggregate ratio of re-serves to imports for the EU

Union Bankof Switzerland(Adler andChang, 1996)

Somereductionplausible

“Reserves are a residual thatresults from central banks leaningagainst the wind of dollar depreci-ation”

Salomon Brothers(Lipsky et al., 1996) None

“In a world of free capital move-ments, trade flows are not a goodguide to the desired scale of re-serves”

Morgan Stanley(Bulchandani, 1997)

Possiblya deficit

Larger portfolio shifts with larger,more liquid euro financial markets

Deutsche Bank(Deutsch, 1997) 50–90 110–150 200

U.S. reserves equal to 1 to 1½months imports

Deutsche Bank(Hoffman andSchröder, 1997) 130

U.S. reserves equal to 1 to 1½months imports

NOTE: Estimates are presented in chronological order of appearance.

thinking from the Bretton Woods era, when capital controls madeimports the first and often the last claim on reserves. When the Bank ofEngland was mobilizing its reserves to defend the pound’s link to themark in September 1992, it was not only U.K. importers on the other

64

side of the market. Imports range from one-tenth to one-third of GDP,but capital flows far exceed GDP (Table C–4).

In practice, central banks accumulate and hold reserves as much as

TABLE C–4

CROSS-BORDER TRANSACTIONS IN BONDS AND EQUITIES

(as a percentage of GDP)

Country 1975 1980 1985 1989 1990 1991 1992 1993 1994 1995 1996

United States 4 9 35 101 89 96 107 129 131 135 163Japan 2 8 62 156 119 92 72 78 60 65 84a

Germany 5 7 33 66 57 55 85 170 158 172 200France n.a. 5 21 52 54 79 122 187 197 187 228Italy 1 1 4 18 27 60 92 192 207 253 468Canada 3 10 27 55 64 81 113 153 212 194 258

SOURCE: National data.NOTE: Figures represent gross purchases and sales of securities between residents and

nonresidents as a percentage of GDP.a Based on settlement data.

a by-product of other policies as a product of reserve policy per se.Fritz Machlup’s likening of reserve size and composition to the contentsof his wife’s closet—a collection of by-products of decisions rather thanthe object of an independent optimization—suffers more from changingsocial norms for acceptable images among economists than from its lossin truth value. A recent attempt to model European reserve holdings,done under genteel duress, produced little in the way of robust results(Leahy, 1997). Contrary to the assertions of some market analyses,63

reserves are not expensive to hold for countries with good credit ratings.Even if surplus reserves can in some sense be identified, is it safe topresume that they will be sold?64 Moreover, caution would suggestdeferring any paring of reserves until the process of monetary union isvery far advanced and the credibility of the ECB is well secured. Theseconsiderations, in combination with the amounts involved and the timehorizon, suggest that any reserve liquidation will prove to be modest inscale and limited in effect.

63 “Excess reserves represent an economic loss,” according to Persaud and Dambassinas(1996, p. 2).

64 Kenen (1995, p. 114) notes that “the EC countries may be stuck with redundantdollars, just as they were stuck with gold after it was demonetized officially by the SecondAmendment to the Articles of Agreement of the IMF.” (European central banks couldeasily take a different view of gold acquired at $35 dollars an ounce, although total returnson dollars and gold measured from a late-1960s base have been converging for sometime.)

65

Appendix D: European Monetary Union and the Structure ofthe Foreign-Exchange Market

It is a commonplace that monetary union in Europe will shrink turnoverin the global foreign-exchange market. A euro area embracing all of theEU countries will deprive foreign-exchange dealers of something like10 percent of their transactions (see Table 5 and BIS, 1997b, p. 92).65

From the standpoint of the participants in the foreign-exchange market(if not from a broader point of view), this contraction of volume threat-ens to arrive at an awkward time. Technical change is already squeezingthe revenue of market participants. Initially, electronic brokeringoffered by Reuters and a consortium of banks was meant to challengethe business of the voice brokers. But medium-sized banks that previ-ously transacted directly with other banks have seen how electronicbrokering has rendered price discovery in the market more transparentand has narrowed trading margins, and they, too, are switching awayfrom direct dealing to electronic brokering. (At this stage, the innova-tion of electronic brokering appears to be on the steepening portion ofits logistic S-curve of diffusion.)

Less well appreciated is the effect of the euro on the structure offoreign-exchange dealing. As things stand, the dollar remains the mainvehicle currency in the foreign-exchange market. Although U.S. GDPand trade represent only one-fifth of the GDP and trade of industrialcountries, the dollar is used on one side of over 80 percent of alltransactions. The decline in the dollar’s role as a vehicle currency hasnot favored a whole matrix of cross-exchange rates not involving thedollar, as modeled by Black (1991). Instead, it has favored the mark,which, as noted in this essay, is to be found on one side of $140 billionof the daily $150 billion in transactions of one EU currency againstanother. (Table 4 shows $300 billion of transactions in EMS currencies,but this figure counts both sides of each transaction, whereas the markfigure above counts only one side.) Thus, not only is a transaction ofFrench francs against Spanish pesetas likely to entail transactionsagainst marks, but a customer transaction of French francs againstdollars is likely to be balanced with a franc/mark transaction and adollar/mark transaction between interbank counterparties.

65 This estimate is not much different from estimates made by Hartmann (1996) andLipsky et al. (1996), which is not surprising considering that all estimates start with theCentral Bank Survey 1995 (BIS, 1996a).

66

Judging from the 1995 data, the euro, at its birth, will trade on aforeign-exchange market in which the dollar is more dominant thantoday. With a broad monetary union, the euro will appear on one sideof 56 percent of all foreign-exchange transactions, larger than the 34 to40 percent share of the mark, but smaller than the 70 percent share ofEU currencies. The dollar will be on one side for nine out of ten dollarsin foreign-exchange transactions, a fraction not observed since 1989(BIS, 1993, pp. 8–9). Exchanges of euros against yen will amount toone-twentieth of exchanges of euros against dollars and one-tenth ofexchanges of yen against dollars. The other sizable exchange-rate pair notinvolving the dollar will be exchanges of euros against Swiss francs, whichmight exceed one-third of transactions of dollars against Swiss francs.

Of course, a smaller euro area would leave more trading of eurosagainst “out” currencies, perhaps the British pound and the Swedishkrona. Hartmann (1996, pp. 21–22) notes that of the noncore Europeancountries, only the United Kingdom would make a material differenceto the structure of the foreign-exchange market by choosing not toadopt the euro. Still, the point would remain that the euro will start offas much less a vehicle currency than the mark, which is another way ofsaying that the mark’s use as a vehicle currency has been largelyconfined to exchanges involving its neighbors’ and near-neighbors’currencies.

It is plausible that the mark is developing into, and that the euro willbecome, the main means of exchange against the Eastern Europeancurrencies. Transactions in these currencies are at present small—over$6 billion per day (Table D–1)—smaller than 1995 transactions betweenthe mark and the guilder, ECU, krona, peseta, or lira. Nevertheless, thequestion is interesting insofar as transactions in these currencies arelikely to grow rapidly. Table D–2 suggests that, except in the CzechRepublic, dollar transactions tend to exceed mark transactions againstlocal currencies on the local foreign-exchange markets in EasternEurope. Although the mark is probably serving as a vehicle for transac-tions between other core European currencies and these emergingcurrencies, it is not obvious that the mark is serving as a vehicle fortransactions involving currencies outside Europe.

Thus, the euro stands to incorporate most of the currencies for whichthe mark plays a vehicle role at present. “The potential of the euro tobecome a forex vehicle for the rest of the world” could start out as purepotential (Hartmann, 1996, p. 23).

67

TABLE D–1

FOREIGN-EXCHANGE TURNOVER IN EMERGING CURRENCIES

(in billions of U.S. dollars)

Local Turnovera Global Turnover

Currency April 1995 April 1996 March 1996b April 1997b Early 1996c

Asia >13.6 >17.8 >16.3 >39.4 36.6Indian rupee 1.6d 1.2 1.0 n.a. 1.1Indonesian rupiah 4.8d 7.8d 3.5 10.0 8.5Korean won 3.1 3.2 1.8 2.4 2.4Malaysian ringgit n.a. n.a. 5.0 10.0 9.5New Taiwan dollar 1.5 1.6 n.a. 3.0 1.1Thai baht 2.6d 4.0d 5.0 14.0 14.0

Latin America 9.1 10.9 >5.8 n.a.Argentine peso 1.7 2.0 n.a. 1.5Brazilian real 4.3e 5.5e 4.5 n.a.Chilean peso 0.8 0.9 n.a. n.a.Colombian peso 0.1d 0.1d 0.1 n.a.New Mexican peso 2.1 2.2 1.2 n.a.New Peruvian sol 0.1 0.2 n.a. n.a.

Eastern Europe 1.8 >5.9 >1.6 8.1Czech koruna 0.6d 2.5d 0.5 5.5Hungarian forint 0.3 0.6 0.3 0.4Polish zloty 0.3d n.a. 0.3 0.35Russian ruble 0.6 2.6 0.5 1.4Slovak koruna 0.02 0.2 n.a. 0.4

Other currencies 5.4 6.7 >7.4 >7.0New Israeli shekel 0.3 0.5 n.a. n.a.Saudi riyal 1.4 1.5 0.3 n.a.South African rand 3.7 4.7 6.0 6.0Turkish lira 0.01d 0.02d 1.1 1.0

Totalf >29.9 >41.3 >31.1 >56.0

SOURCES: Citibank; Singapore Foreign Exchange Market Committee, Annual Report 1996;BIS, Central Bank Survey 1995; national central banks.

NOTE: The countries shown (except South Africa) had an aggregate GDP of $3.4 trillion in1992, or 15 percent of world GDP, compared to 80 percent for the countries included in the April1995 Central Bank Survey.

a Unless otherwise specified, figures are estimates reported by the respective central banks, netof double-counting, for a period as near as possible to April. For Thailand, figures are 1995second-half and 1996 annual averages. For Indonesia and Argentina, they are annual averages.The turnover of the Russian ruble and the South African rand was well above the annual averagein April.

b Citibank estimates, net of double-counting.c Estimates reported in Singapore Foreign Exchange Market Committee, Annual Report 1996.d On a gross basis.e Includes other currencies.f The Central Bank Survey 1995 reports a grand total (including South Africa) of $1,136.9

billion.

68

TABLE D–2

TURNOVER IN EMERGING CURRENCIES, BY CURRENCY IN APRIL 1996(in millions of dollars)

Currency Dollar Mark Yen Total

Eastern Europe 4,786 1,920 48 7,161Czech korunaa 1,025 1,421 0 2,532Hungarian forint 334 105 35 626Polish zloty 863 270 0 1,174Slovak koruna 117 71 12b 200

Asia 10,090 78 145 10,498Indian rupee 1,104 38 11 1,214Korean won 3,082 13 50 3,180New Taiwan dollar 1,924 20 69 2,090Thai bahtc 3,980 7 15 4,014

Other currencies 6,286 >143 >99 6,690New Israeli shekel 385 n.a. n.a. 469Saudi riyal 1,410 3 3 1,494South African rand 4,470 140 96 4,706Turkish liraa 21 0 0 21

SOURCES: National central banks.NOTE: In some cases, the total includes transactions not involving

domestic currency and thus does not match the local turnover shown inTable D–1.

a On a gross basis.b All other.c Annual average, on a gross basis.

Appendix E: Currency Invoicing of International Trade

The importance of the currency invoicing of international trade is easilyoverstated. There was a time when the unit of account for internationaltrade, one of the functions of international money, could be stronglyrelated to the means-of-payment function, as measured by turnover inthe foreign-exchange market. But these days, when world trade turnsover in the global foreign-exchange market twice a week, this relation-ship has lost its strength.66

66 After monetary union, trade will represent something like 10 percent of GDP for theeuro area, the United States, and Japan. By contrast, the international bond and equityflows, alone, exceed GDP for major countries, in some cases by sizable multiples (TableC–4). Contrary to the assumption of Black (1991, p. 522), the denomination of trade canno longer be taken to have much of a direct effect on the use of different currencies inthe foreign-exchange market.

69

What does the contractual currency tell us? If exports are priced indollars, does that mean that private or official external borrowing inforeign currency ultimately secured by these exports should likewise bedenominated in dollars? The question as usually posed misses thedistinction between what might be called the nominal or apparentcurrency of denomination and the effective currency of denomination.The case of gold illustrates this distinction. The gold trade has all alongbeen conducted in dollars. Yet the response of the dollar price of goldto changes in the dollar/mark exchange rate fifteen years ago suggeststhat the price of gold at that time was effectively set more in marksthan in dollars. In contrast, the comparative lack of such an exchange-rate response these days suggests that gold is now truly priced indollars, not only in appearance, but also in substance. Under thesecircumstances, it would have made more sense some years ago than itwould today for South Africa to borrow abroad in European currenciesand to manage the rand against those currencies. The invoicing ofexports of gold offered no clue.

As noted by the Bundesbank (1991, p. 43), moreover, a substantialfraction of the invoicing, especially that of trade in manufactures,reflects the pricing of transactions between wholly owned affiliates ofthe same firm, the invoicing decisions of which may reflect accounting,tax, or organizational choices.

Not only is the question of the denomination of international tradeoften misapprehended, but the data are poor. The very useful effort bythe European Commission (Ilzkovitz, 1995) to bring together data fromthe United States, Japan, Germany, France, the United Kingdom, Italy,and the Netherlands confronted the fact that little information isavailable on the portion of world trade that is growing most rapidly, thatis, trade among developing and emerging countries. Table E–1 isderived from this effort, but its limitations must be understood. Theinvoicing of trade among Asian countries other than Japan is estimatedusing Japanese data, and trade among Latin American countries is takento be a mix of U.S. and European behavior (with two-third and one-third weights). The danger in these quite understandable estimationmethods is that the dollar’s share may be underrepresented. Moreimportant, the information gap implies that we do not really know howinvoicing behavior is evolving over time.

All that said, it appears that there are some fairly robust observations.Only the dollar is used extensively as a vehicle currency in the strictsense, that is, to denominate trade between two other countries. For thebig industrial countries, the bulk of exports tends to be invoiced in the

70

home currency, although this has become less true over time, with nine-

TABLE E–1

INVOICING OF INTERNATIONAL TRADE BY CURRENCY

(in billions of U.S. dollars and percentage of exports)

1980

%

1987

%

1992

Currency World % Intra-EU % Extra-EU %

U.S. dollar (56) (48) 1,741 (48) 141 (4) 1,599 (59)Major EU currencies (31) (34) 1,225 (34) 627 (17) 598 (22)

German mark (14) (16) 559 (15) 297 (8) 263 (10)French franc (6) (7) 230 (6) 117 (3) 114 (4)Dutch guilder (3) (3) 102 (3) 48 (1) 54 (2)Italian lira (2) (3) 124 (3) 62 (2) 62 (2)British pound (7) (6) 208 (6) 103 (3) 105 (4)

Japanese yen (2) (4) 176 (5) 4 (0) 171 (6)Total global exports (100) (100) 3,656 (100) 2,693 (100)

Memorandum:Estimated EU-15 679 (25)

SOURCES: Hartmann, “The Future of the Euro,” 1996, p. 7 (citing Ilzkovitz, 1995);United Nations (for trade data).

tenths of U.S. exports being invoiced in dollars but less than half ofJapanese exports being invoiced in yen.67 This invoicing differencebetween the United States and other industrial countries is consistentwith studies of effective pricing behavior that find that U.S. exportprices reflect domestic prices, whereas exporters to the United Statesshow some tendency to price to the U.S. market. Industrial-countryimports tend to be more dollar-denominated than their exports, reflect-ing the importance of commodity imports. As matters stood in the early1990s, the dollar’s share of trade invoicing was near one-half (TableE–1); its decline since 1980 seems due to the decline in the share of oiltrade (Bundesbank, 1991, p. 42; Ilzkovitz, 1995, p. 71).

The advent of the euro will presumably lead to less use of the dollarto denominate intra-European trade. Whether the dollar will be sup-planted in all its uses—for instance, to denominate energy exports fromthe Netherlands and the United Kingdom to Germany (Bundesbank,

67 Kenen (1983, p. 9 and table 4) notes, by contrast, that exports from industrial coun-tries generally came to be invoiced to a greater extent in the home currency—at theexpense of the dollar—between 1972 and 1976. Kenen’s explanation, “the increase ofuncertainty attending the change in the exchange-rate regime,” would not have predictedthe recent reversal of the earlier trend.

71

1991, p. 42)—remains to be seen.68 But putting aside this question,one can calculate invoicing shares on the hypothesis of a broad mone-tary union using 1992 data on global invoicing practices. The decline inthe use of the euro relative to major EU currencies—from 34 percentof world trade to 22 percent—can be seen as a mechanical, arithmetic,or even misleading, result of the reclassification of intra-EU trade asdomestic (which, however one feels about it on analytic grounds, isincreasingly hard to avoid, given the effect of open borders on Europeanstatistics). Alternatively, the potential reduction in the use of Europeancurrencies might be seen as a result of the largely regional importanceof the deutsche mark at present.

One can summarize the observations by noting that in 1992, thedollar was used to denominate trade 3.6 times the value of U.S. trade,whereas the corresponding intensity for the mark was 1.4, for theFrench franc and British pound, about 1, and for the yen, lira, andguilder, between 0.6 and 0.8. Under the assumption of monetary union,the euro would start off with an intensity of about 1, much like thefranc or pound today. Even this figure may be overstated in that itassumes that intra-European trade is not more intensively denominatedin European currencies than is extra-European trade (Hartmann, 1996),an assumption not justified by the Bundesbank data.

Looking forward, some analysts attempt to arrive at a reasonable rolefor the euro in trade invoicing by suggesting that the euro can beexpected to rise to an intensity of 1.4, much as the mark has today(Persaud and Dambassinas, 1996). This seems modest on its face, buton closer examination, it is not so innocent. As noted above, the markdoes not figure importantly in contracts between third countries. Itshigh use in international trade relative to German trade reflects itsdominance on both sides of German trade with Western Europe—77percent of German exports and 53 percent of German imports (Issing,1996, p. 6).69 Less than half of German imports from other countriesare denominated in marks. To assume that the euro will rise to anintensity of 1.4, therefore, is to posit that the area of heavy euro usewill be as large relative to the euro area as Western Europe is toGermany. For the reasons sketched above in Section 4, the outlook forsuch a development is by no means certain.

68 Contrast Alogoskoufis and Portes (1992, p. 281), who state that “the dollar willcertainly be displaced in intra-EC trade as a result of . . . monetary union.”

69 The figures have fallen from 80 and 60 percent, respectively, in the 1990s; seeDeutsche Bundesbank, 1991, p. 42.

72

Some analysts have tried to reason from prospects for the use of theeuro in the invoicing of trade to portfolio shifts by private investors. Butmore trade invoiced in euros would entail not only more holdings ofbank accounts denominated in euros with which to effect payments butalso more borrowing in euros as the euro-denominated trade paper isdiscounted. Thus, the change in investor preferences or habits as aresult of the greater invoicing of trade in euros needs to be large torepresent a net demand for euro assets.

In summary, much less is known about invoicing behavior than onewould like. Moreover, much of what little is known about trade invoic-ing is not well understood; many conclusions drawn from invoicingpractices regarding economic exposure to exchange-rate changes sufferfrom the fallacy of misplaced concreteness. And the euro should not beexpected quickly to serve as large a role in invoicing in relation to theeuro area’s trade as the mark did in relation to Germany’s trade,because the mark’s outsized role is the flip side of the relatively smallinvoicing role played by the currencies of Germany’s neighbors.

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Domanski, Dietrich, and Holger Neuhaus, “Bond Market Volatility in Germany,”in Financial Market Volatility, BIS Conference Papers No. 1, Basle, Bankfor International Settlements, March 1996, pp. 113–128.

Dooley, Michael J., Saul Lizondo, and Donald J. Mathieson, “The CurrencyComposition of Foreign Exchange Reserves,” International Monetary FundStaff Papers, 36, June 1989, pp. 385–434.

Dornbusch, Rudiger, Carlo Favero, and Francesco Giavazzi, paper presentedto the 26th Panel Meeting of Economic Policy, Bonn, October 17–18, 1997;forthcoming in Economic Policy.

Dornbusch, Rudiger, “Policy and Performance Links between LDC Debtorsand Industrial Nations,” Brookings Papers in Economic Activity, No. 2(1985), pp. 303–368.

Dupont, Dominique, and V. Hugo Juan-Ramon, “Real Exchange Rates andCommodity Prices,” International Monetary Fund Working Paper No. 96/27,Washington, D.C., International Monetary Fund, April 1996.

Edison, Hali J., and Linda S. Kole, “European Monetary Arrangements:Implications for the Dollar, Exchange Rate Variability and Credibility,”Board of Governors of the Federal Reserve System, International FinanceDiscussion Papers, No. 468, Washington, D.C., May 1994.

Eichengreen, Barry, Should the Maastricht Treaty Be Saved? Princeton Studiesin International Finance No. 74, Princeton, N.J., Princeton University,International Finance Section, December 1992.

Eichengreen, Barry, and Tamim Bayoumi, “Is Asia an Optimum CurrencyArea? Can It Become One? Regional, Global and Historical Perspectives onAsian Monetary Relations,” Working Paper No. C96–081, Center forInternational and Development Economics Research, University of Califor-nia, Berkeley, December 1996.

Eichengreen, Barry, and Jeffrey A. Frankel, “Implications of the FutureEvolution of the International Monetary System” in Michael Mussa, JamesM. Boughton, and Peter Isard, eds., The Future of the SDR in Light ofChanges in the International Financial System, Washington, D.C., Interna-tional Monetary Fund, 1996, pp. 337–378.

Emerson, Michael, Daniel Gros, Alexander Italianer, Jean Pisani-Ferry, andHorst Reichenbach, One Market, One Money: An Evaluation of the PotentialBenefits and Costs of Forming an Economic and Monetary Union, Oxfordand New York, Oxford University Press, 1992.

Ettlin, Franz, “On the Fundamental Determinants of the Swiss Franc Ex-change Rate for the D-Mark” in The Determination of Long-Term InterestRates and Exchange Rates and the Role of Expectations, BIS ConferencePapers No. 2, Basle, Bank for International Settlements, August 1996,pp. 18–27.

European Commission, see Commission of the European Communities.European Monetary Institute (EMI), Annual Report 1994, Frankfurt, European

Monetary Institute, April 1995.———, Annual Report 1995, Frankfurt, European Monetary Institute, April 1996.

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———, Annual Report 1996, Frankfurt, European Monetary Institute, April 1997.Frankel, Jeffrey A., “The Implications of Mean-Variance Optimization for Four

Questions in International Macroeconomics,” Journal of International Moneyand Finance, 5 (March 1986), pp. 553–575.

———, “Still the Lingua Franca: The Exaggerated Death of the Dollar,”Foreign Affairs, 74 (July-August 1995), pp. 9–16.

Frankel, Jeffrey A., and Shang-Jin Wei, “Trade Blocs and Currency Blocs,”National Bureau of Economic Research Working Paper No. 4335, Cam-bridge, Mass., National Bureau of Economic Research, April 1993.

———, “Yen Bloc or Dollar Bloc? Exchange Rate Policies of the East AsianEconomies,” in Takatoshi Ito and Anne O. Krueger, eds., MacroeconomicLinkage: Savings, Exchange Rates, and Capital Flows, Chicago, University ofChicago Press, 1994, pp. 295–329.

Frenkel, Jacob A., and Morris Goldstein, “The International Role of theDeutsche Mark,” in Fifty Years of the Deutsche Mark, Frankfurt, DeutscheBundesbank, forthcoming 1997.

Funke, Norbert, and Michael Kennedy, “International Economic Implicationsof the Euro,” OECD Economic Outlook, 61 (June 1997), pp. 24–30.

Galati, Gabriele, “Trade Links, Business Cycle Symmetries and CurrencyLinks,” Working Paper, Basle, Bank for International Settlements, forth-coming 1997.

Galati, Gabriele, and Robert N. McCauley, “Explaining the Dollar/MarkPolarity,” Working Paper, Basle, Bank for International Settlements, forth-coming 1997.

Garber, Peter M., “The Use of the Yen as a Reserve Currency,” Institute forMonetary and Economic Studies, Bank of Japan, Monetary and EconomicStudies, 14 (December 1996), pp. 1–21.

Ghironi, Fabio, and Francesco Giavazzi, “Policy Implications of the Size ofEMU for Europe and the United States,” in Paul R. Masson, Thomas H.Krueger, and Bart G. Turtelboom, eds., EMU and the International Mone-tary System, Washington, D.C., International Monetary Fund, 1997, pp.421–477.

Giavazzi, Francesco, and Alberto Giovannini, Limiting Exchange Rate Flexibil-ity, Cambridge, Mass., MIT Press, 1989.

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Hamada, Koichi, “Comment on ‘Yen Bloc or Dollar Bloc?’” in Takatoshi Ito andAnne O. Krueger, eds., Macroeconomic Linkage: Savings, Exchange Rates,and Capital Flows, Chicago, University of Chicago Press, 1994, pp. 329–331.

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Hartmann, Philipp, “The Future of the Euro as an International Currency: ATransactions Perspective,” Centre for European Policy Studies ResearchReport, No. 20, (December 1996), pp. 1–28.

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Illmanen, Antii, “EMU Trades: Insights from Post-1999 Forward Rates,”Salomon Brothers Economic and Market Analysis, Euro Strategist, May 21,1997, pp. 18–22.

Ilzkovitz, Fabienne, “Recent Developments in the International Use of Cur-rencies: Towards a Tripolar Regime?” in ECU Institute, ed., InternationalCurrency Competition and the Future Role of the Single European Currency,London and Boston, Kluwer Law International, 1995, pp. 67–95.

———, “Prospects for the Internationalization of the Euro,” European Com-mission, June 1996, pp. 1–15, processed.

International Energy Agency, World Energy Outlook, Paris, InternationalEnergy Agency, 1996.

International Monetary Fund, Exchange Arrangements and Exchange Restric-tions, Annual Report, Washington, D.C., International Monetary Fund, 1997.

Issing, Otmar, “Mögliche Auswirkungen der Europäischen Währungsunion aufdie internationalen Finanzmärkte,” speech before Internationalen Zins-Forum, Frankfurt, December 2, 1996, in Deutsche Bundesbank, Auszüge ausPressartikeln, No. 76/6, December 1996.

Jeanneau, Serge, “Interest Rate Futures: Characteristics and Market Develop-ment” in Bank for International Settlements, International Banking andFinancial Market Developments, November 1995 and February 1996.

Johnson, Christopher, In with the Euro, Out with the Pound: The SingleCurrency for Britain, London, Penguin, 1996.

Johnson, Karen H., “International Dimension of European Monetary Union:Implications for the Dollar,” Board of Governors of the Federal ReserveSystem International Finance Discussion Paper No. 469, Washington, D.C.,May 1994.

Keating, Giles, “Forex Reserves After EMU: Ample Dollars,” Credit Suisse

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First Boston, Economics Research—Europe, June 4, 1996.Kenen, Peter B., The Role of the Dollar as an International Currency, Occa-

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Melbourne, Cambridge University Press, 1995.———, Sorting Out Some EMU Issues, Reprints in International Finance No.

29, Princeton, N.J., Princeton University, International Finance Section,December 1996.

———, “Preferences, Domains, and Sustainability,” American Economic Review,87 (May 1997), pp. 211–213.

Kindleberger, Charles P., Balance-of-Payments Deficits and the InternationalMarket for Liquidity, Essays in International Finance No. 46, Princeton, N.J.,Princeton University, International Finance Section, May 1965.

———, “The Dollar Yesterday, Today and Tomorrow,” Banca Nazionale delLavoro Quarterly Review, 155 (December 1985), pp. 295–308.

———, World Economic Primacy, 1500–1990, New York, Oxford UniversityPress, 1996.

Kindleberger, Charles P., with Emile Despres, and Walter Salant, “The Dollarand World Liquidity: a Minority View,” The Economist, 218, No. 6389,February 5, 1966; reprinted in Kindleberger, International Money, London,Allen & Unwin, 1981, pp. 42–52.

King, Stephen, “European Monetary Union: Four Endings and a Funeral,”London, HSBC James Capel Economics, 3rd quarter, 1996.

Koch, Elmar B., “Exchange Rates and Monetary Policy in Central Europe,”Most, 7 (1997), pp. 1–48.

Koo, Richard C. “Japan and International Capital Flows,” presentations toNomura Central Bank Seminar, Tokyo, Nomura Research Institute, April1992–1996.

Krugman, Paul, “The International Role of the Dollar: Theory and Prospect,”in John F. O. Bilson and Richard C. Marston, eds., Exchange Rate Theoryand Practice, Chicago, University of Chicago Press, 1984, pp. 261–278.

Kwan, C. H., Economic Interdependence in the Asia-Pacific Region: Towardsa Yen Bloc, London and New York, Routledge, 1994.

Lascelles, David, “The Crash of 2003: An EMU Fairy Tale,” No. 25, London,Centre for the Study of Financial Innovation, December 1996.

Laxton, Douglas, and Eswar Prasad, “Possible Effects of European MonetaryUnion on Switzerland: A Case Study of Policy Dilemmas Caused by LowInflation and the Nominal Interest Rate Floor,” International Monetary FundWorking Paper No. 97/23, Washington, D.C., International Monetary Fund,February 1997.

Leahy, Michael P., “The Dollar as an Official Reserve Currency under EMU,”Open Economies Review, 7 (January 1997), pp. 371–390.

Lipsky, John, et al., Managing Convergence: Market Implications for 1997 andBeyond, Economic & Market Analysis, New York, Salomon Brothers,December 1996.

McCauley, Robert N., “Prospects for an Integrated European Government

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Bond Market,” in Bank for International Settlements, International Bankingand Financial Market Developments, August 1996, pp. 18–31.

McCauley, Robert N., Frank Iacono, and Judith S. Rudd, Dodging Bullets:Changing U.S. Corporate Capital Structures in the 1980s and 1990s,Cambridge, Mass., MIT Press, forthcoming 1998.

McCauley, Robert N., and Will Melick, “Risk Reversal Risk,” Risk (November1996a), pp. 54–57.

———, “Propensity and Density,” Risk (December 1996b), pp. 52–54.McCauley, Robert N., and William R. White, “The Euro and European

Financial Markets,” in Paul R. Masson, Thomas H. Krueger, and Bart G.Turtelboom, eds., EMU and the International Monetary System, Washington,D.C., International Monetary Fund, 1997, pp. 324–388.

McCauley, Robert N., and Stephen Yeaple, “How Lower Japanese Asset PricesAffect Pacific Financial Markets,” Federal Reserve Bank of New YorkQuarterly Review, 19 (Spring 1994), pp. 19–33.

Martin, Phillipe, “The Exchange Rate Policy of the Euro: A Matter of Size?”CEPR Discussion Paper No. 1646, London, Centre for Economic PolicyResearch, May 1997.

Masson, Paul R., and Bart G. Turtelboom, “Characteristics of the Euro, theDemand for Reserves, and Policy Coordination Under EMU,” in Paul R.Masson, Thomas H. Krueger, and Bart G. Turtelboom, eds., EMU and theInternational Monetary System, Washington, D.C., International MonetaryFund, 1997, pp. 194–224.

Mauro, Paolo, “Current Account Surpluses and the Interest Rate Island inSwitzerland,” International Monetary Fund Working Paper No. 95/24,Washington, D.C., International Monetary Fund, February 1996.

Maystadt, Philippe, “Implications of EMU for the IMF,” in Paul R. Masson,Thomas H. Krueger, and Bart G. Turtelboom, eds., EMU and the Interna-tional Monetary System, Washington, D.C., International Monetary Fund,1997, pp. 146–153.

Monticelli, Carlo, and Luca Papi, European Integration, Monetary Co-ordination,and the Demand for Money,OxfordandNew York, Oxford University Press, 1996.

Mundell, Robert, “EMU and the International Monetary System,” in Guillermode la Dehesa, Alberto Giovannini, Manual Guitián, and Richard Portes, TheMonetary Future of Europe, London, Centre for Economic Policy Research,1993.

Murray, Stewart, Philip Klapwijk, Hester le Roux, and Paul Walker, Gold 1997,London, Gold Field Mineral Services Limited, 1997.

O’Neill, James, Andrew Bevan, and Martin Brookes, “Some Thoughts on theEuro,” in Goldman Sachs, The Weekly Analyst, No. 96/20, London, May 28,1996.

Oppers, S. Erik, “Trends in the International Use of the U.S. Dollar,” Wash-ington, D.C., International Monetary Fund, June 1995, processed.

Owens, Adrian, “Dollar’s Role Under Threat,” Julius Baer Investments Limited,London, July 2, 1996.

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Padoa-Schioppa, Tommaso, “Policy Cooperation and the EMS Experience,” inWillem H. Buiter and Richard C. Marston, eds., International EconomicPolicy Coordination, Cambridge and New York, Cambridge University Press,1985, pp. 331–355.

Padoa-Schioppa, Tommaso, and Fabrizio Saccomanni, “What Role of the SDRin a Market-Led International Monetary System?” in Michael Mussa, JamesM. Boughton, and Peter Isard, eds., The Future of the SDR in Light ofChanges in the International Financial System, Washington, D.C., Interna-tional Monetary Fund, 1996, pp. 378–386.

Parsons, Nick, “The Euro and Central Bank Reserves,” Paribas Capital MarketsInternational Research, EMU Countdown, September 9, 1996, pp. 14–18.

Persaud, Avinash D., “The EMU Calculator,” JP Morgan, Foreign ExchangeResearch, October 16, 1996.

Persaud, Avinash D., and Dimitris Dambassinas, “Euro, FX Reserves andVehicle Currencies,” JP Morgan, Foreign Exchange Research, August 29,1996; revised September 13, 1996.

Porter, Richard D., and Ruth A. Judson, “The Location of U.S. Currency: HowMuch of It Is Abroad,” Federal Reserve Bulletin, 82 (October 1996), pp.883–903.

Radzyner, Olga, and Sandra Riesinger, “Exchange Rate Policy in Transition:Developments and Challenges in Central and Eastern Europe,” in Oester-reichische Nationalbank, Focus on Tradition, Vienna, 1996, pp. 20–38.

Rogoff, Kenneth, “Foreign and Underground Demand for Euro Notes: Blessingor Curse?” paper presented to the 26th Panel Meeting of Economic Policy,Bonn, October 17–18, 1997; forthcoming in Economic Policy.

Ruskin, Alan, “Euro ≠ D–Mark. Q.E.D. Coming Changes in the Central BankReserve Equation,” I.D.E.A. Occasional Paper No. 7, London, I.D.E.A.,June 1996.

Saccomanni, Fabrizio, “Towards ERM 2: Managing the Relationship betweenthe Euro and the Other Currencies of the European Union,” Banca Nazion-ale del Lavoro Quarterly Review, 49 (December 1996), pp. 385–403.

Seth, Rama, and Robert N. McCauley, “Financial Consequences of New AsianSurpluses,” Federal Reserve Bank of New York Quarterly Review, 12(Summer 1987), pp. 32–44.

Singapore Foreign Exchange Market Committee, Annual Report 1996, Singa-pore, Singapore Foreign Exchange Market Committee, 1997.

Sjaastad, Larry A., and Fabio Scacciavillani, “The Price of Gold and theExchange Rate,” Journal of International Money and Finance, 15 (December1996), pp. 879–897.

Spaventa, Luigi, “Coexisting with the Euro: Prospects and Risks after Verona,”in Peter B. Kenen, ed., Making EMU Happen: Problems and Proposals: ASymposium, Essays in International Finance No. 199, Princeton, N.J.,Princeton University, International Finance Section, August 1996, pp. 50–63.

Stüdemann, Frederick, “Political Pressure ‘Likely to Hit ECB,’” FinancialTimes, September 12, 1997, p. 2.

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Svensson, Lars E. O., “The Simplest Test of Target Zone Credibility,” Interna-tional Monetary Fund Staff Papers, 38 (September 1991b), pp. 655–665.

Taguchi, Hiroo, “On the Internationalization of the Yen,” in Takatoshi Ito andAnne O. Krueger, eds., Macroeconomic Linkage: Savings, Exchange Rates,and Capital Flows, Chicago, University of Chicago Press, 1994, pp. 335–355.

Tavlas, George S., On the International Use of Currencies: The Case of theDeutsche Mark, Essays in International Finance No. 181, Princeton, N.J.,Princeton University, International Finance Section, March 1991.

Tavlas, George S., and Yazuru Ozeki, The Internationalization of Currencies: AnAppraisal of the Japanese Yen, Occasional Paper No. 90, Washington, D.C.,International Monetary Fund, January 1992.

Thornhill, John, “Estonia Likely to Link Its Currency to Euro,” FinancialTimes, May 12, 1997, p. 3.

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PUBLICATIONS OF THEINTERNATIONAL FINANCE SECTION

Notice to Contributors

The International Finance Section publishes papers in four series: ESSAYS IN INTER-NATIONAL FINANCE, PRINCETON STUDIES IN INTERNATIONAL FINANCE, and SPECIALPAPERS IN INTERNATIONAL ECONOMICS contain new work not published elsewhere.REPRINTS IN INTERNATIONAL FINANCE reproduce journal articles previously pub-lished by Princeton faculty members associated with the Section. The Section wel-comes the submission of manuscripts for publication under the following guidelines:

ESSAYS are meant to disseminate new views about international financial mattersand should be accessible to well-informed nonspecialists as well as to professionaleconomists. Technical terms, tables, and charts should be used sparingly; mathemat-ics should be avoided.

STUDIES are devoted to new research on international finance, with preferencegiven to empirical work. They should be comparable in originality and technicalproficiency to papers published in leading economic journals. They should be ofmedium length, longer than a journal article but shorter than a book.

SPECIAL PAPERS are surveys of research on particular topics and should besuitable for use in undergraduate courses. They may be concerned with internationaltrade as well as international finance. They should also be of medium length.

Manuscripts should be submitted in triplicate, typed single sided and doublespaced throughout on 8½ by 11 white bond paper. Publication can be expedited ifmanuscripts are computer keyboarded in WordPerfect 5.1 or a compatible program.Additional instructions and a style guide are available from the Section.

How to Obtain Publications

The Section’s publications are distributed free of charge to college, university, andpublic libraries and to nongovernmental, nonprofit research institutions. Eligibleinstitutions may ask to be placed on the Section’s permanent mailing list.

Individuals and institutions not qualifying for free distribution may receive allpublications for the calendar year for a subscription fee of $40.00. Late subscriberswill receive all back issues for the year during which they subscribe. Subscribersshould notify the Section promptly of any change in address, giving the old addressas well as the new.

Publications may be ordered individually, with payment made in advance. ESSAYSand REPRINTS cost $8.00 each; STUDIES and SPECIAL PAPERS cost $11.00. Anadditional $1.50 should be sent for postage and handling within the United States,Canada, and Mexico; $1.75 should be added for surface delivery outside the region.

All payments must be made in U.S. dollars. Subscription fees and charges forsingle issues will be waived for organizations and individuals in countries whereforeign-exchange regulations prohibit dollar payments.

Please address all correspondence, submissions, and orders to:

International Finance SectionDepartment of Economics, Fisher HallPrinceton UniversityPrinceton, New Jersey 08544-1021

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List of Recent Publications

A complete list of publications may be obtained from the International FinanceSection.

ESSAYS IN INTERNATIONAL FINANCE

170. Shafiqul Islam, The Dollar and the Policy-Performance-Confidence Mix. (July1988)

171. James M. Boughton, The Monetary Approach to Exchange Rates: What NowRemains? (October 1988)

172. Jack M. Guttentag and Richard M. Herring, Accounting for Losses OnSovereign Debt: Implications for New Lending. (May 1989)

173. Benjamin J. Cohen, Developing-Country Debt: A Middle Way. (May 1989)174. Jeffrey D. Sachs, New Approaches to the Latin American Debt Crisis. (July 1989)175. C. David Finch, The IMF: The Record and the Prospect. (September 1989)176. Graham Bird, Loan-Loss Provisions and Third-World Debt. (November 1989)177. Ronald Findlay, The “Triangular Trade” and the Atlantic Economy of the

Eighteenth Century: A Simple General-Equilibrium Model. (March 1990)178. Alberto Giovannini, The Transition to European Monetary Union. (November

1990)179. Michael L. Mussa, Exchange Rates in Theory and in Reality. (December 1990)180. Warren L. Coats, Jr., Reinhard W. Furstenberg, and Peter Isard, The SDR

System and the Issue of Resource Transfers. (December 1990)181. George S. Tavlas, On the International Use of Currencies: The Case of the

Deutsche Mark. (March 1991)182. Tommaso Padoa-Schioppa, ed., with Michael Emerson, Kumiharu Shigehara,

and Richard Portes, Europe After 1992: Three Essays. (May 1991)183. Michael Bruno, High Inflation and the Nominal Anchors of an Open Economy.

(June 1991)184. Jacques J. Polak, The Changing Nature of IMF Conditionality. (September 1991)185. Ethan B. Kapstein, Supervising International Banks: Origins and Implications

of the Basle Accord. (December 1991)186. Alessandro Giustiniani, Francesco Papadia, and Daniela Porciani, Growth and

Catch-Up in Central and Eastern Europe: Macroeconomic Effects on WesternCountries. (April 1992)

187. Michele Fratianni, Jürgen von Hagen, and Christopher Waller, The MaastrichtWay to EMU. (June 1992)

188. Pierre-Richard Agénor, Parallel Currency Markets in Developing Countries:Theory, Evidence, and Policy Implications. (November 1992)

189. Beatriz Armendariz de Aghion and John Williamson, The G-7’s Joint-and-SeveralBlunder. (April 1993)

190. Paul Krugman, What Do We Need to Know About the International MonetarySystem? (July 1993)

191. Peter M. Garber and Michael G. Spencer, The Dissolution of the Austro-Hungarian Empire: Lessons for Currency Reform. (February 1994)

86

192. Raymond F. Mikesell, The Bretton Woods Debates: A Memoir. (March 1994)193. Graham Bird, Economic Assistance to Low-Income Countries: Should the Link

be Resurrected? (July 1994)194. Lorenzo Bini-Smaghi, Tommaso Padoa-Schioppa, and Francesco Papadia, The

Transition to EMU in the Maastricht Treaty. (November 1994)195. Ariel Buira, Reflections on the International Monetary System. (January 1995)196. Shinji Takagi, From Recipient to Donor: Japan’s Official Aid Flows, 1945 to 1990

and Beyond. (March 1995)197. Patrick Conway, Currency Proliferation: The Monetary Legacy of the Soviet

Union. (June 1995)198. Barry Eichengreen, A More Perfect Union? The Logic of Economic Integration.

(June 1996)199. Peter B. Kenen, ed., with John Arrowsmith, Paul De Grauwe, Charles A. E.

Goodhart, Daniel Gros, Luigi Spaventa, and Niels Thygesen, Making EMUHappen—Problems and Proposals: A Symposium. (August 1996)

200. Peter B. Kenen, ed., with Lawrence H. Summers, William R. Cline, BarryEichengreen, Richard Portes, Arminio Fraga, and Morris Goldstein, FromHalifax to Lyons: What Has Been Done about Crisis Management? (October1996)

201. Louis W. Pauly, The League of Nations and the Foreshadowing of the Interna-tional Monetary Fund. (December 1996)

202. Harold James, Monetary and Fiscal Unification in Nineteenth-Century Germany:What Can Kohl Learn from Bismarck? (March 1997)

203. Andrew Crockett, The Theory and Practice of Financial Stability. (April 1997)204. Benjamin J. Cohen, The Financial Support Fund of the OECD: A Failed

Initiative. (June 1997)205. Robert N. McCauley, The Euro and the Dollar. (November 1997)

PRINCETON STUDIES IN INTERNATIONAL FINANCE

61. Stephen A. Schuker, American “Reparations” to Germany, 1919-33: Implicationsfor the Third-World Debt Crisis. (July 1988)

62. Steven B. Kamin, Devaluation, External Balance, and Macroeconomic Perfor-mance: A Look at the Numbers. (August 1988)

63. Jacob A. Frenkel and Assaf Razin, Spending, Taxes, and Deficits: International-Intertemporal Approach. (December 1988)

64. Jeffrey A. Frankel, Obstacles to International Macroeconomic Policy Coordina-tion. (December 1988)

65. Peter Hooper and Catherine L. Mann, The Emergence and Persistence of theU.S. External Imbalance, 1980-87. (October 1989)

66. Helmut Reisen, Public Debt, External Competitiveness, and Fiscal Disciplinein Developing Countries. (November 1989)

67. Victor Argy, Warwick McKibbin, and Eric Siegloff, Exchange-Rate Regimes fora Small Economy in a Multi-Country World. (December 1989)

68. Mark Gersovitz and Christina H. Paxson, The Economies of Africa and the Pricesof Their Exports. (October 1990)

69. Felipe Larraín and Andrés Velasco, Can Swaps Solve the Debt Crisis? Lessons

87

from the Chilean Experience. (November 1990)70. Kaushik Basu, The International Debt Problem, Credit Rationing and Loan

Pushing: Theory and Experience. (October 1991)71. Daniel Gros and Alfred Steinherr, Economic Reform in the Soviet Union: Pas

de Deux between Disintegration and Macroeconomic Destabilization. (November1991)

72. George M. von Furstenberg and Joseph P. Daniels, Economic Summit Decla-rations, 1975-1989: Examining the Written Record of International Coopera-tion. (February 1992)

73. Ishac Diwan and Dani Rodrik, External Debt, Adjustment, and Burden Sharing:A Unified Framework. (November 1992)

74. Barry Eichengreen, Should the Maastricht Treaty Be Saved? (December 1992)75. Adam Klug, The German Buybacks, 1932-1939: A Cure for Overhang?

(November 1993)76. Tamim Bayoumi and Barry Eichengreen, One Money or Many? Analyzing the

Prospects for Monetary Unification in Various Parts of the World. (September1994)

77. Edward E. Leamer, The Heckscher-Ohlin Model in Theory and Practice.(February 1995)

78. Thorvaldur Gylfason, The Macroeconomics of European Agriculture. (May 1995)79. Angus S. Deaton and Ronald I. Miller, International Commodity Prices, Macro-

economic Performance, and Politics in Sub-Saharan Africa. (December 1995)80. Chander Kant, Foreign Direct Investment and Capital Flight. (April 1996)81. Gian Maria Milesi-Ferretti and Assaf Razin, Current-Account Sustainability.

(October 1996)82. Pierre-Richard Agénor, Capital-Market Imperfections and the Macroeconomic

Dynamics of Small Indebted Economies. (June 1997)83. Michael Bowe and James W. Dean, Has the Market Solved the Sovereign-Debt

Crisis? (August 1997)

SPECIAL PAPERS IN INTERNATIONAL ECONOMICS

16. Elhanan Helpman, Monopolistic Competition in Trade Theory. (June 1990)17. Richard Pomfret, International Trade Policy with Imperfect Competition. (August

1992)18. Hali J. Edison, The Effectiveness of Central-Bank Intervention: A Survey of the

Literature After 1982. (July 1993)19. Sylvester W.C. Eijffinger and Jakob De Haan, The Political Economy of Central-

Bank Independence. (May 1996)

REPRINTS IN INTERNATIONAL FINANCE

28. Peter B. Kenen, Ways to Reform Exchange-Rate Arrangements; reprinted fromBretton Woods: Looking to the Future, 1994. (November 1994)

29. Peter B. Kenen, Sorting Out Some EMU Issues; reprinted from Jean MonnetChair Paper 38, Robert Schuman Centre, European University Institute, 1996.(December 1996)

88

The work of the International Finance Section is supportedin part by the income of the Walker Foundation, establishedin memory of James Theodore Walker, Class of 1927. Theoffices of the Section, in Fisher Hall, were provided by agenerous grant from Merrill Lynch & Company.

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